Let's Review the Mortgage Market - Juicy Yields and Strong Fundamentals. But How to Invest?
After strong performance in July, risk assets came under pressure later in the third quarter as the S&P 500 posted a quarterly decline of 3.70%.
Mortgage REITs (represented by FTSE NAREIT Mortgage Plus Capped Index) declined ~2% in 3Q2023. Despite this decline, similar to the second quarter, this subsector outperformed the broader REIT index, the Russell 2000, and the Dow Jones Industrial Average.
Some non-Agency residential mortgage REITs and servicers still ended the quarter trading at sizeable discounts to tangible book value and double-digit dividend yields. Given the continued rise in long-term interest rates, we believe mortgage REITs and servicers with significant interest rate hedges and large holdings of mortgage servicing rights (MSRs) are poised to generate attractive returns in the coming quarters.
In the structured credit market, non-Agency RMBS credit spreads continued to tighten similar to the second quarter. Spreads for AAA senior bonds tightened marginally for non-QM (the new subprime) but tightened slightly more for Single Family Rental (SFR). Spread tightening was more pronounced for mezzanine credit risk transfer bonds as bond buyers gained conviction of stability in the housing market.
Legacy RMBS continued to exhibit wide bid/ask spreads as liquidity was challenged amid an uncertain interest rate environment.
On the Agency (government guaranteed) MBS side, the basis (or spread over Treasury bonds) ended the quarter roughly 14 bps wider than the second quarter. This again is a similar trend compared to the previous quarter with Agency MBS spreads ending the third quarter significantly wider than the historical average. The “current coupon” Agency MBS bond ended the quarter yielding ~6.40% which, in our opinion, represents an attractive buying opportunity for a security with no credit risk.
Short term corporate bonds issued by mortgage REITs/servicers continued to appreciate in price. This part of the market continued to attract new investors, presumably enticed by relatively short duration and yields in the 8-12% range.
At the end of September, the S&P CoreLogic Home Price Index was released and showed home prices increased close to 1% month over month. Morgan Stanley’s research team also recently revised its 2023 home price forecast to positive for 2023.
The following factors continue to be supportive forces for home prices:
Low inventory driven by a long-term underproduction of housing
A record amount of borrower equity due to appreciation and a lack of “cash-out refis”
Borrower “lock-in effect” as mortgage rates have climbed significantly
Demographic trends supportive of household formation and baby boomers “aging in place”
Overall, we believe investors should benefit from owning securities that have solid/relatively predictable fundamentals, above-average income, and double-digit return potential. Given the recent pullback in equity and bond prices, we see plenty of opportunities “across the capital structure”.