M o r t g a g e Primer - Part 2 j a n n e y fixed income strategy Mortgages in a Portfolio Context is the second of a three-part series covering the role of agency MBS in a diversified fixed income portfolio. DIVERSIFICATION INTO MBS YIELD CURVE STRATEGIES PASSTHROUGH VS Introduction Mortgages in a Portfolio Context is the second of a three-part series on the agency mortgage bond markets, preceded by Mortgage Basics (Pt 1) and to be followed by a discussion of Relative Value in Mortgages (Pt 3). As discussed in Part 1, agency mortgage backed securities (MBS) are bonds backed by a pool of underlying home loans and guaranteed by the issuing agency, making them a low credit risk investment option; individual bonds meanwhile have varying degrees of interest rate risk. At $6.9 trillion in par amount (one-fifth of all US debt outstanding), agency mortgage bonds are the second largest US fixed income asset class, and any fully diversified bond portfolio should contain an allocation to the mortgage sector. Timing risk means that monthly payments from agency MBS may be uncertain, but also allows mortgages to provide a higher yield than otherwise similar investments. This timing risk also creates a source of diversification away from traditional fixed income instruments. For a moderate risk tolerance investor, we believe agency MBS holdings should range from 15% - 35% of fixed income portfolios, depending mainly on ability to accept this timing risk, as well as relative value considerations. Mortgage Basics A Refresher Guy LeBas Chief Fixed Income Strategist 215 665 6034 glebas@janney.com Part 1 of our Mortgage Primer, Mortgage Basics, identified the key descriptive, risk, and return characteristics of agency mortgage backed securities. We ll briefly review those characteristics, with a focus on those which will be most crucial to understanding how mortgages can best fit into a fixed income portfolio. Agency passthroughs are simply packages of mortgage loans grouped together into a bond and guaranteed by the issuing agency Fannie Mae, Freddie Mac, and Ginnie Mae against losses from foreclosure. These passthroughs most commonly carry 30 or 15 year final maturities and pay both principal and interest each month, meaning that an investor will receive her principal investment back in advance of that final maturity date. Level Pay Mortgages, Most Common Type, Pay Down Principal Each Month See page 5 for important information regarding certifications, our ratings system as well as other disclaimers. MORTGAGES PAGE 1 $100,000 Loan 30yrs @ 5% Scheduled Monthly Payment: $537 Mth 1: Interest $417, Principal $120 Mth 2: Interest $416, Principal $121... Mth 360: Interest $2, Principal $535
What most differentiates MBS from other types of bonds is timing risk, the potential that homeowners will prepay their loans at a faster (or slower) than anticipated pace and investors will receive their cash back sooner (or later) than expected. Typically, prepays accelerate and investors receive their cash back sooner when interest rates have fallen, requiring those investors to reinvest in a lower interest rate environment. Conversely, prepays slow when rates rise, a time when investors would prefer to have their cash back to reinvest at higher rates. It s this timing risk that means MBS generally carry a higher yield than otherwise comparable credit quality instruments, such as fixed maturity agency bonds. It s also this timing risk which gives mortgage bonds a unique source of return and portfolio diversification benefits over traditional fixed income securities. Annual Return of Principal on a 30yr Passthrough Varies With Prepayment Speed 25% 20% Prepayament Speed: 200 PSA Prepayament Speed: 500 PSA 15% 10% 5% Timing risk as to when an investor will receive principal back is what differentiates mortgages from other types of bonds. 0% 0 5 10 15 20 25 Diversification Benefits Finance 101 teaches that there s a close connection between risk and return: on average, a riskier investment will have a higher return than a less risky investment. Philosophically speaking, we can break down the return of any fixed income investment based on its risks, most commonly interest rate and credit risk. For example, a long term government bond has high interest rate risk (its price will fluctuate with changes in interest rates), but low credit risk (there s little chance the bond will default). In this instance, we can say that the bond earns its return predominately from interest rate, not credit, risk. The opposite would be true for a short term single B rated corporate bond that bond would earn its return predominately from credit, not interest rate, risk. That same Finance 101 thinking teaches that it s important to diversify, but what s lost in the practical application is that diversification needs to take place across risk factors, not simply across different types of investment (stock vs bond, etc). For example, traditional diversification suggests that investment in a US bank stock and an Italian government bond creates diversification, but both of those investments are highly exposed to investor fears, meaning that their true diversification is much less than the investments names might imply. The primary characteristic which makes agency MBS different from other securities, timing risk, means that MBS provide a major source of risk factor diversification in fixed income portfolios. In addition, this type of risk also means MBS offer a higher level of return than other, similar-quality securities without timing risk. While the majority of fixed income securities earn their return from a combination of interest rate risk and credit risk, agency mortgage bonds earn their return primarily from interest rate risk and timing risk and with interest rates as low as they are, the timing risk component has grown. Although the level of diversification isn t perfect, portfolios which have an allocation to the agency mortgage markets can diversify along three dimensions rather than just two. MORTGAGES PAGE 2
Mortgage Bonds with More Variable Average Lives Generally Carry Higher Yields 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 30yr 4% Passthrough ("High" Timing Risk) Yield 2.95% Expected Avg Life: 3.8yrs under unchanged interest rates 10.9yrs under a 3% increase in interest rates 15yr 3% Passthrough ("Low" Timing Risk) Yield 2.48% Expected Avg Life: 4.4yrs under unchanged interest rates 6.4yrs under a 3% increase in interest rates 0.00% 0yrs 2yrs 4yrs 6yrs 8yrs 10yrs 12yrs 14yrs Average Life Our recommended allocations to the agency mortgage market will generally range from 15-35% for moderate risk investors, depending on short term interest rate conditions. The key to establishing the portion of a taxable investment portfolio which can and should be allocated to the agency mortgage markets lies in identifying the cashflow needs of that portfolio. Although agency MBS generally pay monthly cashflow, the timing risk inherent in mortgage bonds means that investors cannot be certain as to the amount of that monthly cashflow. As a result, investors with a low need for cashflow certainty for example, investors saving for retirement some years off can and should maintain a higher allocation to the mortgage markets than investors with a high need for cashflow certainty for example, investors living off the proceeds of a portfolio. Janney Fixed Income Strategy s asset allocation model sets a range for allocations to the agency mortgage markets of 15% - 35% of a portfolio for investors able to accept a moderate degree of risk. Janney Moderate Fixed Income Asset Allocation a/o 4Q 2011 MORTGAGES PAGE 3 Yield Curve Strategies Given their timing risk-based nature, agency mortgage bonds are an effective tool to express expec-
tations for interest rates. This effectiveness stems from the performance of different types of mortgages under various interest rate scenarios. The most straightforward mortgage yield curve strategy involves looking at various price and coupon mortgage bonds to establish which bonds are likely to earn higher returns based on a set of interest rate expectations. As we noted above, mortgage prepayments accelerate when interest rates fall and more homeowners look to refinance. Discount-priced mortgage bonds benefit from faster prepayments; hence, a common and successful yield curve strategy to take advantage of expected lower interest rates is to purchase mortgage passthroughs and CMOs priced below par. Conversely, when interest rates are more likely to rise, premium-priced bonds tend to outperform, prescribing a strategy of purchasing above-par, higher coupon mortgages when interest rates have a high probability of rising. The below table provides a series of basic strategies for various interest rate environments. Expectation Tactical Strategy Coupon Strategy Interest Rates Declining Interest Rates Rising Purchase 30yr PTs and longer-term CMOs Purchase 15yr PTs and shorter CMOs with "extension protection" Purchase discount-priced PTs and CMOs with moderate to higher risk levels to profit from faster prepays Purchase premium-priced PTs and CMOs with higher coupon to blunt effects of higher rates Specific types of bonds within the mortgage universe respond better to falling versus rising interest rates. Passthroughs vs CMOs Passthroughs are the simplest form of mortgage backed security and are created by packaging a group of loans together and passing through the cashflows on that package to bond investors. While there are various types of passthroughs 30 year and 15yr being the fixed rate most common the basic characteristics of each group of passthroughs are similar. Collateralized mortgage obligations, by contrast, are more complex and customized than passthroughs, and two CMOs, even ones that are backed by the same group of underlying loans, can have significantly different levels of interest rate and timing risk. As a result, the tradeoff between buying passthroughs versus CMOs is generally one of active trading versus customization. Passthroughs trade more actively, with a narrower bid/ask spread when buying and selling, whereas CMOs are more diverse in the levels of potential risk and return. For that reason, while we like passthroughs for investors who take a more active approach to trading (and perhaps use MBS for tactical plays on interest rates), we generally prefer CMO structures for longer term strategically-oriented investors owing to their more customizable risk and return characteristics. Conclusion We view the agency mortgage markets as an important component of any diversified fixed income portfolio, based not just on the fact that agency MBS comprise one-fifth of the US debt markets, but more importantly based on the unique risk and return characteristics of mortgage securities. In addition to the sector s very strong credit characteristics, depending on timing risk inherent in mortgages as a source of returns provides diversification tough to obtain though other asset classes. As a result, the Janney Fixed Income Asset Allocation for a moderate risk investor recommends that long term allocations to the mortgage sector range from 15% - 35% of fixed income portfolios, depending on relative value and other shorter term considerations. Part 3 of our Mortgage Market Primer series will focus on opportunities and relative value trades in the current economic and interest rate climate. MORTGAGES PAGE 4
Analyst Certification I, Guy LeBas, the Primarily Responsible Analyst for this report, hereby certifiy that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Definition of Outlooks Positive: Janney FIS believes there are apparent factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the Barclay s U.S. Aggregate Bond Market Index as a benchmark. Treasuries: Janney FIS ratings employ the Barclay s U.S. Treasury Index as a benchmark. Agencies: Janney FIS ratings employ the Barclay s U.S. Agency Index as a benchmark. Mortgages: Janney FIS ratings employ the Barclay s U.S. MBS Index as a benchmark. Investment Grade Credit: Janney FIS ratings employ the Barclay s U.S. Credit Index as a benchmark. High Yield Credit: Janney FIS ratings for employ Barclay s U.S. Corporate High Yield Index as a benchmark. Municipals: Janney FIS ratings employ the Barclay s Municipal Bond Index as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change. Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor. MORTGAGES PAGE 5