Income Manager That Has Outperformed S&P 500 Since 2009 Discusses Key Questions Regarding RMBS

William Van de Water, Portfolio Manager
William R. Van de Water, Portfolio Manager is portfolio manager of an event-driven, non-agency RMBS strategy at Rational Funds. He joined ESM as a RMBS analyst and trader in June 2009 and became a managing director in December 2009. In 2014, Mr. Van de Water became a co-portfolio manager at ESM Management. From 2005 through March 2009, Mr. Van de Water worked in the Boston office of Susquehanna International Group. His primary responsibility was to analyze, and trade mortgage backed securities. Mr. Van de Water earned joint B.S. degrees in Physics, Business, Economics, and Management from the California Institute of Technology in 2005.

Residential Mortgage Backed Securities (RMBS), which offer a premium over similarly rated corporate bonds, seek to provide Financial Advisors and their clients higher yields and a steady stream of income over the long term. In the following article, William Van de Water, an income portfolio manager, addresses some frequently asked questions about the asset class and why it is becoming a popular choice for Financial Advisors and their clients.

What is Non-Agency debt?

Hundreds of billions of dollars of mortgages are issued every year Mortgages that meet certain government requirements (loan size, LTV ratio, etc.) can be sold to or guaranteed by government backed agencies, including Fannie Mae, Freddie Mac, and Ginnie Mae. Pools of these mortgages are packaged together to create “agency residential mortgage backed securities,” or simply “agency RMBS.”

Mortgages that are not guaranteed by government agencies can be packaged up and sold privately as customized securities; these are known as “non-agency residential mortgage backed securities” (or just “NARMBS”).

NARMBS are not standardized in any way, and each deal can be different from every other deal. However, in general they are securitized and tranched, whereby junior bonds in the securitization take the first losses and senior bonds are more protected from losses because of the subordination structure.

What are the primary risks in having exposure to NARMBS?

No pool of NARMBS is issued with the idea that it will not suffer losses; i.e. losses are expected. The question becomes what are the loss assumptions that you should make when analyzing a bond. As a bond holder, you are exposed to the credit of the underlying borrowers and the fluctuations in market value of the underlying collateral (the houses). Which bonds you acquire, in terms of seniority, determines the amount of risk that you take as an investor. A good way to minimize risk is by primarily owning senior tranches of these structures and by screening securities based on, among other things, delinquency rates.

What makes for good credits in this market space?

Loans issued before 2008 correspond to borrowers who survived the housing crisis and either kept up with their mortgage payments or had them modified to the extent that they are capable of making the payments. When you combine this with the fact that they likely have more equity through scheduled principal payments and appreciation in their home values, these borrowers should be viewed as good credits in terms of their mortgage loans.

Should investors trade based on a bond’s rating?

No, while credit ratings might be a good gauge for many corporate bonds, we believe that ratings are not a good guide for judging NARMBS, especially ratings on pre-2008 bonds. During the early stages of the 2008 crisis, ratings agencies either dramatically lowered their ratings or pulled their ratings on these bonds altogether. The credit rating paradigm is not particularly useful for distressed MBS. For example, a bond that has incurred a loss from defaulted mortgage loans will be forever rated as defaulted even if hypothetically the remaining loans in the pool have no credit risk at all. The correct way to view credit risk in MBS is to analyze the credit risk of the loans relative to the remaining bonds structures and the bond price.

Where is the opportunity in NARMBS?

Simply investing in NARMBS can offer investors an attractive yield. In the case of pre-2008 bonds, we believe the yields are very attractive given the real risk that is taken on relative to other fixed income issues. For the reasons stated above, the credit risk associated with NARMBS is much less than what the perceived risk is. This is despite higher yields on a relative basis to other bonds. While a simple yield from smart investing is good, additional opportunities in this space arise from structural issues with bonds that can be exploited for significant upside. We also believe that there is a misconception that, as the pre-2008 market size shrinks, opportunity in the space is also shrinking. In fact, we believe that the opportunity set is increasing as the size of the market is shrinking.

As mentioned above, each NARMBS securitization is governed by its own prospectus. We also mentioned that each of these structures anticipated losses from losses to underlying mortgages. The documents were written to account for these expected losses. However, the realized severity of losses was not contemplated and very little attention in the governing documents was paid to how should things work in such an extreme environment.

In terms of increasing opportunity, the market is underpricing the bonds of many issuers in the space. In addition, as the market size shrinks, few players remain in the space, leaving investors to find and exploit these issues with less competition.

What are returns expected to look like going forward?

Because of the process involved with identifying problems with particular bonds, acquiring those bonds and resolving the issue can take significant time, we expect the returns to be somewhat lumpy. Trades can take anywhere from a few days to a few years to reach their ultimate payoff. In some instances, there will be some increase in the mark-to-market value of the bonds along the way, but in most cases, there is a single point in time resolution that will be reflected over a short period of time as the market adjusts to the appropriate pricing of the bond or the fund liquidates its position.

It is important to bear in mind that with many event-driven trade ideas, the market has not priced in any likelihood of the desired outcome; therefore, the market is effectively pricing in a 0% chance of the outcome. Unlike other trading strategies, there is a very asymmetrical expected return with no downside, just smaller upside. Either the trade will make 25% or the trade will make a baseline yield. Obviously other market factors can cause losses, but the trade thesis being incorrect will not negatively affect performance.