Bond Investors' Next Big Trade Is Betting on U.S. Homeowners

(Bloomberg) -- One of the best bond trades of 2018 might be one of the top from this year: betting that U.S. homeowners won't default on their mortgages.

Money managers piled into relatively new Fannie Mae and Freddie Mac bonds known as "credit risk transfer" securities in 2017 in part because they are floating rate, a boon when the Federal Reserve is projecting three rate hikes in the coming year. Investors who bought subprime mortgage bonds after the housing crisis for pennies on the dollar are now getting repaid about $80 billion of principal a year, and are looking to reinvest their funds somewhere.

"It's been an incredible year for the space," said Dave Goodson, who heads mortgage-backed securities and related bonds at Voya Investment Management, which manages $230 billion. "It's becoming better and better established. We like that."

The riskier credit-risk transfer debt returned more than 10 percent this year through Dec. 1, according to Bank of America Corp. data, outpacing 7.2 percent returns on U.S. high-yield bonds and 5.9 percent for investment-grade corporate securities. Next year, portions of the bonds could return 3 percent on top of government debt, according to Morgan Stanley analysts. They call CRT bonds “the place to be” in 2018, and list parts of the securities among their top buys for the year for structured finance globally.

Investors buying these securities are among the first to suffer losses when homeowners fail to make their payments. But with unemployment at just 4.1 percent in November and the U.S. economy growing at an annualized rate faster than 3 percent, it seems reasonable to bet that prime borrowers will continue to pay their home loans, Goodson said. He prefers the securities to commercial real estate or corporate debt, which may face downturns sooner.

There are also technical reasons for the bonds to perform well next year. Fannie Mae and Freddie Mac said they probably will sell around $13 billion of credit-risk transfer securities in their main programs next year. If even a fraction of the $80 billion of subprime mortgage bond principal that investors are expected to get back in 2018 goes into this market, prices could rise, said Michael Canter, who oversees mortgage bonds, asset-backed securities and related debt at AllianceBernstein, which manages $549 billion.

“As legacy RMBS winds down, there are more investors looking for assets they can purchase to get exposure to residential credit,” Canter said. “This is the most obvious way to do that.”

Fannie Mae and Freddie Mac began issuing credit risk transfer securities in 2013 as a way to offload some of their risk onto taxpayers. The two companies guarantee homeowners' mortgage payments against default, and when the U.S. took over the failing enterprises in 2008 during the financial crisis, their obligations explicitly became the government's. Previously, taxpayers backing was only implicit.

Here's how it works: Fannie Mae and Freddie Mac sell CRT bonds tied to a pool of home loans that have been packaged into mortgage-backed securities they guarantee. The Fannie Mae notes are called Connecticut Avenue Securities, while Freddie Mac's are Structured Agency Credit Risk notes.

If the underlying loans sour, CRT holders' principal goes toward paying back mortgage bond holders. The way the deals are put together, Fannie Mae and Freddie Mac are usually the first to take losses, then bond holders take some portion of subsequent losses, and the two companies take whatever losses remain after that.

Another possible tailwind for the bonds is that Fannie Mae and Freddie Mac are separately considering changing the structure of the securities to make them more appealing to real estate investment trusts. REITs have bought about 10 percent of the riskier mezzanine portion of CRT bonds issued by Fannie Mae this year, and as much as 23 percent of slices of Freddie Mac offerings this year, according to data from the GSEs. The REIT changes would shift the way they desginate and document loans, which would also reduce taxes on the securities for overseas investors. That may spur demand from funds domiciled abroad.

The securities' successful year has some investors hunting for opportunities elsewhere. Gene Tannuzzo, a money manager at Columbia Threadneedle, which manages $484 billion, said that after watching the bonds rally, he's been locking in gains on the securities and looking at opportunities in non-performing and re-performing loan market instead.

"It's too tight," Tannuzzo said. "We felt a little more comfortable earlier on."

Investors' faith in the product was tested earlier this year during Hurricane Harvey and Hurricane Irma. Jittery holders sparked a selloff across the debt, though most of the bonds have since bounced back. Payments reports on the bonds in 2018 may calm investors, according to Bank of America analysts led by Chris Flanagan. The bank expects hurricane-related losses to total less than 0.02 percent on the bonds because most affected homes had wind and flood insurance.

"Given global warming, I think the hurricane season is a little scary for this sector," said Tracy Chen, head of structured credit at Brandywine Global, which manages $74 billion. 

Even so, she says she's expecting another robust year for the securities, assuming fixed-income assets generally remain strong. "If high-yield and emerging markets continue to tighten, I don't see any reason CRT can't continue to tighten as well," Chen said.

To contact the reporter on this story: Claire Boston in New York at cboston6@bloomberg.net.

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Rick Green at rgreen18@bloomberg.net, Dan Wilchins

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