Finding Relative Value in Mortgage-Backed Securities

Importantly, these asset classes have the potential to generate attractive risk-adjusted returns, especially when compared to investment-grade corporate debt. In addition to being an effective diversifier, possessing higher ratings with the ability to invest based on risk tolerance due to tranching and having more predictable cash flows provide for a customizable solution. 

The $9.7 trillion Agency RMBS market offers products such as TBAs, passthroughs and Agency CMOs. Guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, these securities can offer stability and a strong risk profile, presenting convexity risk but minimal credit risk.

On the other hand, the CMBS market, worth $1.7 trillion, is currently in a significant phase. It is worth noting that office-related financing accounts for less than 20% of commercial real estate debt. Market dislocation, in part due to higher interest rates and evolving societal habits such as the shift to e-commerce and longer-lasting work from home evolution, has resulted in the undervaluation of high-quality bonds. These factors, along with the anticipation that the Federal Reserve may soon cut interest rates, have contributed to price stabilization and what we see as attractive buying opportunities.

Credit enhancement is a critical feature in CMBS, underpinning the asset class’s creditworthiness and appeal to investors. It functions as a financial buffer that protects senior tranches from initial losses. This allows for the structured layering of risk, where more junior pieces absorb losses first, thereby shielding the more senior tranches and enhancing their ratings over time. The presence of credit enhancement in CMBS transactions reassures investors of the credit quality and resilience of their investments, even in the event of underlying asset performance issues.

The below chart demonstrates the relative yield advantages of single-asset, single-borrower CMBS over unsecured corporate debt across various credit ratings. Particularly noteworthy is the yield on AAA-rated single-asset single-borrower CMBS, which is considerably more attractive than even BB-rated corporate bonds, suggesting a mispricing that experienced investors with scale and relationships with issuers and sell-side traders can take advantage of.

For CMBS, we believe the market's mispricing offers an entry point. The market has effectively marked to market through secondary trading activity, allowing for price discovery that might not be reflected in bank portfolios. Notably, single-asset, single-borrower CMBS in major metropolitan areas, like office towers in Chicago, provide particularly attractive opportunities due to their yields and spreads.

Additionally,  spreads between Agency RMBS and corporates also indicate that government-backed securities offer competitive returns, often at a lower risk profile. In the current landscape, Agency RMBS are trading at historic wides due to factors like bank retrenchment from the market following the March 2023 bank failures. However, these conditions also create potential tailwinds: a reduced supply of new securities due to higher mortgage rates and the prospect of financial institutions returning to the market, creating a favorable environment for value investment in Agency RMBS.

For insurers seeking to maximize yield and income for their portfolios, RMBS and CMBS may present compelling opportunities. Agency RMBS offer a lower-risk profile with potentially higher returns, while CMBS provides opportunities to capitalize on market inefficiencies and credit enhancements. A combination of risk tranches and predictable cash flows found in this market can create an effective source of enhanced yield potential to support an insurer’s overall business and liabilities. With prudent security selection, investors may stand to benefit by including structured products within their overall fixed income asset allocation.

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This material contains the opinions of certain professionals at MacKay Shields but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ^©2024, MacKay Shields LLC. All Rights Reserved. 

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COMPARISONS TO AN INDEX

Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.

RISKS OF INVESTING IN ASSET AND MORTGAGE-BACKED SECURITIES

One of the principal risks of mortgage-related and asset-backed securities is that the underlying debt may be prepaid ahead of schedule if interest rates fall, thereby reducing the value of an investment.  If interest rates rise, there is less prepayment risk but defaults may increase, potentially causing losses. This is not a complete list of risks associated with the strategy. Consult your professional advisors for further guidance.

SOURCE INFORMATION

“Bloomberg^®”, “Bloomberg Indices^®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.

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