As expected by many analysts, the Fed raised rates at their June meeting, and another two hikes are expected before year’s end. Historically, rate hikes have put downward pressure on both the fixed income and equities markets, making it a somewhat challenging landscape to navigate as an investor.
Assets like equities are particularly sensitive to interest rate hikes for a few reasons. Higher bond yields push some investors out of the stock market, thereby decreasing demand, and there can be residual effects on corporate earnings (when money isn’t as cheap). The bond market gets equally beaten as higher yields make fixed-rate bonds sink in value.
Not all assets fall into this pattern. Seasoned non-agency residential mortgage-backed securities (NASDAQ:RMBS) should weather higher-rate scenarios for reasons which are discussed here.
Higher rates tend to signal a strong economy
The Fed raises interest rates to keep the economy from overheating. The post-Great Recession era was a manufactured, near-zero interest rate environment, a move by the Fed to boost spending and in turn, economic growth. Over the last few years, the Fed has raised interest rates steadily as the economy recovered and even boomed.
Broadly, the Fed would – or should - not raise rates if the economy were on the brink of collapse. Consumer spending is strong, the labor market is in recovery and demand is booming. These ingredients have typically brewed a healthy economy, and a strong economy has traditionally led to increased asset prices, chief amongst which is housing.
This impact on housing prices is important for the seasoned non-agency RMBS market for two reasons. First, an increase in housing prices benefits the underlying credit story: now one-third or even halfway through their mortgage schedule, a generic pre-crisis borrower’s monthly payment is growing as to the principal portion. This means that their pace of mortgage balance reduction is increasing. This reduction in principal leads to a natural credit improvement, but continuing increases in the home price make the improvement even more dramatic. The borrower now has greater equity in a more valuable asset.
Second, many of these seasoned non-agency RMBS have floating-rate coupons, which increase along with rates. At some point there may be issues such as mortgage rate (WAC) caps and other security-specific considerations as to how much the coupon can float. However, for at least an initial period where rates increase, the floating coupon in conjunction with the improvement in the sector’s credit should help offset some of the downward move experienced by traditional fixed income.
Seasoned borrowers are survivors
The seasoned non-agency RMBS market is backed by borrowers who have survived a “once-in-a-lifetime, category five storm,” and made it out the other side. The borrowers are both viable and resilient. Given their thin credit profile, lower FICO, limited documentation, or any other blight which forced them into an alternative credit product in the first place, they were expected to be amongst the first to default when the housing market crashed. To be sure, many similar borrowers did not make it. However, those still in their homes and in the collateral pools have been able to realize significant improvement in home equity and now have a decade-plus of payment history.
Modifications, special programs and the like have assisted many borrowers in this way, but whatever the case, the remaining borrowers now have deeper incentive to continue servicing their mortgages since their home equity is that much higher. Further, they have more options available such as potential refinance, potential sale or similar for them to retain/realize their home equity – all a far cry from the days in the aftermath of the crisis when their mortgages were upside-down. A hike in interest rates is likely not enough to shake these deeply-seeded roots.
Typical bonds are expected to suffer in rates-higher scenarios, but with the right combination of specific fundamentals and structure, seasoned non-agency RMBS could buck the traditional trend.
Disclosure: I am/we are long SEASONED NON-AGENCY RMBS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The AlphaCentric Income Opportunities Fund invests in seasoned non-agency RMBS, the asset discussed in this article.