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, Columbia Threadneedle 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 already gained as much as 6.9 percent this year according to Bank of America Corp. 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 dialed down their exposure to mortgage bonds and ramped up 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. “It’s the sector we probably have the highest conviction on.”
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 like mortgage-backed securities and 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, a trade group.
Bank of America, using a different data set, says about 37 percent 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 manages more than $1 trillion and has been reducing high-yield exposure in favor 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 percent this year, and those backed by subprime home loans have returned about 6.9 percent, according to Bank of America, outpacing junk’s 5.5 percent gain and investment-grade’s 4.8 percent increase. Even bonds backed by relatively safe jumbo loans have risen 5.5 percent.
Gene Tannuzzo, a money manager at Columbia Threadneedle, which oversees $473 billion, said that after those gains, non-agency mortgage bonds still offer better returns given the risk. He’s been buying mortgage-backed securities rated BBB, which can yield 4 percent to 4.5 percent. He’s less attracted to high-yield debt, where average yields have sunk to as low as 5.4 percent this month, far below their five-year average of 6.3 percent, according to Bloomberg Barclays index data.
“A percent or less is not that much of a give-up when you’re talking about going from a speculative-grade asset class to a higher-quality one,” Tannuzzo said.
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 percent off their lowest levels, making the collateral for the loans more valuable. Mortgage default rates have been falling since peaking at 5.7 percent in 2009, according to data from S&P Global Ratings and Experian. It hit a post-crisis low of 0.6 percent 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 like junk bonds, Morgan Stanley strategists said in an Aug. 9 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, which has $33 billion in assets. Even so, he said he’s been adding mortgage bonds and other structured products, while cutting his exposure to high-yield debt.
That crisis-era taint can help investors, said Ashish Shah, head of fixed income and chief investment officer of global credit at AllianceBernstein, which manages $517 billion.
“I think that’s why there’s good value that remains in that space,” Shah said.
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