According to Bloomberg, The Next Big Trade for Bond Investors Is Betting on U.S. Homeowners.
I think it might be a good idea to start thinking about investing in CRTs of GSE. I need to fully understand CRTs.
In the past, this meant that we kept all of the credit risk associated with our guarantee. After the housing crisis, we knew that we needed to develop a more flexible business model where we could share some of this risk with investors. However, this market literally didn’t exist, which meant that in order to fulfill our goal, we had to create an entirely new market from scratch.
The Next Big Trade for Bond Investors Is Betting on U.S. Homeowners – from Bloomberg
By
Claire Boston
December 26, 2017, 4:01 AM PST
- Credit risk transfer bonds among best-performing debt of year
- Planned tax changes may draw new investors to the securities
Here’s What Tulips and the Great Recession Have in Common
Here’s What Tulips and the Great Recession Have in Common
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.
U.S. Housing Bond Bet Outperforms Junk, EM
Portions of credit-risk transfer bonds have returned more than 10 percent this year
Source: Bank of America Corp., Bloomberg Barclays data
Note: CRT returns are based on lower loan-to-value issuance group
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.
CRT Takes Off
The market has grown to more than $40 billion in four years
Source: Sifma
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.
One interesting discussion from SimSla and Tim Howard
Tim –
Bloomberg discussed this on TV this morning.
A Starbridge Capital analyst (or M.D.) discussed how these had larger spreads over Treasuries, REITS, and MBSs, but have tightened closer to MBS & REITS, but still offered an attractive investment option for “bond investors”.
They discussed the biggest risk to buyers of CRTs was a series of uninsured natural disasters followed by a national housing price decline.
One question I still have is the about the “flow of funds” and the transferability of the CRTs. Right now CRTs involve an upfront payment from the buyer to the GSEs. Then a flow of interest payments from the GSEs to the buyer of the CRTs. Then, if there is “credit event”, the buyer of CRTs will reverse the flow of funds to the GSEs (if I understand this correctly). I believe that the most a buyer of the CRT could lose would be the coupon payments and the principal invested. If that is the case, then counterparty risk shouldn’t be an issue as the final principal payment could be offset rather than receiving a check from the owner of the CRT.
However, if principal is paid any earlier than the final payment, then if CRTs are transferred to a weaker counterparty, it could create serious issues if there is a credit event.
Is there currently counterparty risk with the CRTs and are they transferable?
Like
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There is no counterparty risk with Fannie and Freddie’s CRTs, and for that reason the transferability issue you raise really isn’t a concern.
Fannie or Freddie receive cash proceeds when they sell a CRT tranche to an investor. At the end of each quarter, the companies pay interest on the outstanding principal of the tranche (although technically, I think I recall that it’s the principal outstanding at the end of the previous quarter) at the stated rate of interest, which is a spread over 1-month LIBOR. The principal of Fannie and Freddie’s CRT tranches can be reduced by both scheduled and unscheduled mortgage repayments, as well as “credit events,” i.e., losses allocated to that tranche. A tranche repayment is passed through to the investor as an early reduction in principal, where a credit event is an actual LOSS of principal, in which the investor ultimately will receive less principal–either in prepayments or at maturity–than they initially put into the deal, by the cumulative amount of the credit events. There never is a payment from the investor to Fannie or Freddie (which would give rise to counterparty risk) because of credit losses.
TimelessInvestor
Should I consider invest in bonds of GSE?
According to Bloomberg, The Next Big Trade for Bond Investors Is Betting on U.S. Homeowners.
I think it might be a good idea to start thinking about investing in CRTs of GSE. I need to fully understand CRTs.
“Credit risk transfers” could the hottest securities next year – from the realdeal.com
In the past, this meant that we kept all of the credit risk associated with our guarantee. After the housing crisis, we knew that we needed to develop a more flexible business model where we could share some of this risk with investors. However, this market literally didn’t exist, which meant that in order to fulfill our goal, we had to create an entirely new market from scratch.
The Next Big Trade for Bond Investors Is Betting on U.S. Homeowners – from Bloomberg
By
Claire Boston
December 26, 2017, 4:01 AM PST
Here’s What Tulips and the Great Recession Have in Common
Here’s What Tulips and the Great Recession Have in Common
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.
U.S. Housing Bond Bet Outperforms Junk, EM
Portions of credit-risk transfer bonds have returned more than 10 percent this year
Source: Bank of America Corp., Bloomberg Barclays data
Note: CRT returns are based on lower loan-to-value issuance group
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.
CRT Takes Off
The market has grown to more than $40 billion in four years
Source: Sifma
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.
One interesting discussion from SimSla and Tim Howard
Tim –
Bloomberg discussed this on TV this morning.
A Starbridge Capital analyst (or M.D.) discussed how these had larger spreads over Treasuries, REITS, and MBSs, but have tightened closer to MBS & REITS, but still offered an attractive investment option for “bond investors”.
They discussed the biggest risk to buyers of CRTs was a series of uninsured natural disasters followed by a national housing price decline.
One question I still have is the about the “flow of funds” and the transferability of the CRTs. Right now CRTs involve an upfront payment from the buyer to the GSEs. Then a flow of interest payments from the GSEs to the buyer of the CRTs. Then, if there is “credit event”, the buyer of CRTs will reverse the flow of funds to the GSEs (if I understand this correctly). I believe that the most a buyer of the CRT could lose would be the coupon payments and the principal invested. If that is the case, then counterparty risk shouldn’t be an issue as the final principal payment could be offset rather than receiving a check from the owner of the CRT.
However, if principal is paid any earlier than the final payment, then if CRTs are transferred to a weaker counterparty, it could create serious issues if there is a credit event.
Is there currently counterparty risk with the CRTs and are they transferable?
Like
There is no counterparty risk with Fannie and Freddie’s CRTs, and for that reason the transferability issue you raise really isn’t a concern.
Fannie or Freddie receive cash proceeds when they sell a CRT tranche to an investor. At the end of each quarter, the companies pay interest on the outstanding principal of the tranche (although technically, I think I recall that it’s the principal outstanding at the end of the previous quarter) at the stated rate of interest, which is a spread over 1-month LIBOR. The principal of Fannie and Freddie’s CRT tranches can be reduced by both scheduled and unscheduled mortgage repayments, as well as “credit events,” i.e., losses allocated to that tranche. A tranche repayment is passed through to the investor as an early reduction in principal, where a credit event is an actual LOSS of principal, in which the investor ultimately will receive less principal–either in prepayments or at maturity–than they initially put into the deal, by the cumulative amount of the credit events. There never is a payment from the investor to Fannie or Freddie (which would give rise to counterparty risk) because of credit losses.
About Timeless Investor
My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.