Some big investors are getting so antsy about corporate junk debt that once-unloved mortgage bonds look safe in comparison.Brian Jackson
Some big investors are getting so antsy about corporate junk debt that once-unloved mortgage bonds look safe in comparison.
Pacific Investment Management Co., Goldman Sachs Asset Management and others are snatching up bonds tied to subprime mortgages and other home loans made before the housing crisis, while selling speculative-grade company debt. They say junk yields are too low for the risk investors are taking, and securities backed by mortgages – which have gained as much as 6.9 per cent this year according to Bank of America data – offer higher potential returns given the risk.
These switches in portfolios are the latest sign that a bull market in corporate credit may be losing steam. In the decade after a financial crisis caused by the U.S. subprime meltdown, many investors dialled down their exposure to mortgage bonds and bolstered their holdings of corporate debt, which performed well in late 2008 and 2009 and often seemed safer. Now, the U.S. mortgage market is showing signs of strength, and at this stage in the credit cycle, buying securities linked to home loans may make sense, even if it may mean giving up some yield, investors said.
"Housing has got legs," said Mark Kiesel, chief investment officer of global credit at Pacific Investment Management Co, which manages $1.6-trillion (U.S.). "It's the sector we probably have the highest conviction on."
Mr. Kiesel said he expects housing prices to appreciate, which will help non-agency mortgage securities, or bonds backed by home loans without government guarantees. If instead home values falter in a mild recession, the securities can still eke out positive returns. Pimco recommended trimming exposure to high-yield bonds and equities and shifting to less risky assets such as mortgage-backed securities and U.S. Treasuries in an asset-allocation report this month.
The market for non-agency mortgage-backed securities has shrunk dramatically since the financial crisis. There were about $800-billion outstanding in the middle of 2017, down from $2.8-trillion a decade ago, according to the Securities Industry and Financial Markets Association.
Bank of America, using a different data set, says about 37 per cent of the securities are backed by subprime loans. The rest are supported by other mortgages ineligible for government guarantees, such as "jumbo" loans that are too big for U.S. backing. While some firms have issued these notes in recent years, the majority of the securities outstanding were originally sold before the financial crisis. "There's lots of demand and shrinking supply," said Mike Swell, co-head of global fixed-income portfolio management at Goldman Sachs Asset Management, which has been reducing high-yield exposure in favour of mortgage-backed securities and other structured products. "We think it will be much better protected in the event that volatility picks up and you see risk assets like high yield do poorly."
Bonds backed by "Alt-A" mortgages, which were often taken out by borrowers unable to document their income, have gained around 6.3 per cent this year, and those backed by subprime home loans have returned about 6.9 per cent, according to Bank of America, outpacing junk's 5.5-per-cent gain and investment-grade's 4.8-per-cent increase. Even bonds backed by relatively safe jumbo loans have risen 5.5 per cent.
Investors are betting on housing after years of mortgage credit having been relatively tight. The absolute level of mortgages outstanding has fallen since the crisis, to $8.7-trillion from $9.3-trillion, according to the Federal Reserve Bank of New York. And U.S. home prices have risen an average of 45 per cent off their lowest levels, making the collateral for the loans more valuable. Mortgage default rates have been falling since peaking at 5.7 per cent in 2009, according to data from S&P Global Ratings and Experian. It hit a postcrisis low of 0.6 per cent earlier this year.
In junk bonds, meanwhile, protections for corporate lenders and bond investors have eroded. Junk-rated borrowers tend to have less subordinated debt now, meaning there are fewer other creditors to absorb losses when a company fails. Debt levels have risen relative to assets, which also weighs on how much investors recover if a corporate borrower goes under. With the Federal Reserve scaling down its balance sheet, there will be less demand for riskier assets such as junk bonds, Morgan Stanley strategists said in a note.
Some investors have to hold their noses to convince themselves to buy non-agency mortgage bonds again. "There's still a level of concern that the past is never quite the past," said Eric Johnson, chief investment officer of CNO Financial Group. Even so, he said he's been adding mortgage bonds and other structured products, while cutting his exposure to high-yield debt.