Brexit-related uncertainty in the market has created a pronounced demand for U.S. Treasuries. This flight to so-called "safe-havens" is the market's reaction to the clouded future of the global economy. Britain's exit from the EU will take two or more years to complete on its own, and uncertainty associated with this is exacerbated by other countries contemplating their own Brexit-style moves. Combined, these events stirred market fears and the race to dump "risky" assets.
Selloffs engulfed the stock market and credit-related fixed income (both investment grade and high yield) in the days after the Brexit vote. Credit-based structured products such as asset-backed securities (NYSE:ABS) and non-agency residential mortgage backed securities (NASDAQ:RMBS) experienced reduced flows and wider indicative markets, but no definitive moves lower.
Further, in days since the initial down moves, the overall market has stabilized at lower U.S. Treasury rate levels, and stocks and credit-related sectors have in fact rallied. This suggests a constructive environment for non-agency RMBS for various reasons:
No sign of "Forced Sellers"
A flood of "forced sellers" to the market is traditionally a sign of economic instability. The term typically means holders are in a must-sell position due to events such as redemptions or withdrawal requests and thus are forced to sell to raise funds. This was prevalent during the financial crisis in 2008. Lately, its resurgence has been assumed as funds' underperformance and overall market volatility have led to investor reluctance to remain in the market.
However, immediately post-Brexit, various credit-based structured product sectors instead reported a 5:1 ratio of buyers (i.e. those looking for bargains) to sellers (i.e. forced/required selling). The low-rate environment is naturally better for mortgage borrowers, so stability in securities pricing and a better fundamental landscape for underlying borrowers are both positives.
While RMBS are not to be mistaken as a safe-haven alternative to traditional U.S. Treasuries, the asset presents more compelling yield profiles. To the extent that bond prices are not forced down, the superior yields in this asset class can be realized based on performance of the underlying borrowers as opposed to technical selling pressure.
Shelter via limited supply and lower rates
There are factors which support a positive environment for the non-agency space overall. Traders have cited limited supply and natural amortization, aspects which contribute to more steady performance since most of the asset class is very seasoned and what remains has survived the 2008 crisis.
Further, as mentioned, lower rates are a positive for mortgage borrowers, as they will be able to consider opportunities for refinancing or servicing their debt at lower rates. For these reasons, the sector should see less downward pressure vis-à-vis other risk asset sectors.
Always being cognizant of this rally in U.S. Treasuries, which connotes participants' risk aversion, investors can remain opportunistic if in fact selling does emerge or the chance to buy at lower levels presents itself. Fundamentals can easily get thrown out the door when everybody is running for safe havens, but similarly, these positive features should contribute to better performance when the environment normalizes.
Bid-ask and liquidity will likely remain the biggest issues until a clearer picture emerges. Interestingly, this picture could have more to do with investors' risk appetites than with economic fundamentals, as that word has meant less and less in this Central Bank/QE-supported macro environment.
As investors flock to U.S. Treasuries, it's clear that the uncertainty plaguing the market is driving investments toward so-called safer, reliable assets. Still, there exist good prospects for solid ultimate returns in the non-agency RMBS space.
Disclosure: I am/we are long MORTGAGE BACKED SECURITIES.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.