BKT: Agency MBS Are A Great Hedge Against Volatility In Equities

Summary

• Agency MBS is a sector with a low level of volatility, which can come in handy during periods of uncertainty.
• Mortgage delinquencies continued to decline last quarter on a year-over-year basis, suggesting a low level of credit risk to investors.
• The refinancing index is quite high right now, which may pressure forward yields. However, even if BKT sees a distribution cut, its leveraged yield and its discount will remain attractive.
• This idea was first discussed with CEF/ETF Income Laboratory, a marketplace subscription service launched by Stanford Chemist.

Main Thesis

The purpose of this article is to evaluate the BlackRock Income Trust (NYSE:BKT) as an investment option at its current market price. Mortgage debt is an asset class I have been recommending for quite a while, and I continue to see merit in owning it today. With the market in "risk-off" mode right now, I believe moving up in credit quality and relative safety makes a lot of sense. With this mindset, I believe BKT offers a great value proposition. The fund is comprised almost exclusively of agency MBS, which are typically of better credit quality than their non-agency MBS counterparts. Further, the fund sports a healthy discount to NAV, as well as a very attractive income stream.

Some downsides do exist of course. Refinancing activity has picked up markedly since late last year. The new issuance coming out at lower, prevailing interest rates will undoubtedly pressure the future income stream of BKT and funds like it. Further, housing starts are on the rise, which could increase the new supply of MBS very soon. If demand wavers, this increase will impact the underlying value of the assets in BKT's portfolio. However, I see the positive aspects of the fund, as well as declining delinquency rates for mortgages nation-wide, as strong enough catalysts to outweigh these risks for now.

Background

First, a little background on BKT. The fund is managed by BlackRock (BLK), and its objective is to "manage a portfolio of high-quality securities to achieve both preservation of capital and high monthly income", primarily through exposure of agency mortgage backed securities. Currently, BKT trades at $6.13/share and yields 6.73% annually by paying monthly distributions. I covered BKT for the first time in November when I recommended it as a safe way to play the housing market. In hindsight, this was a good call, as BKT has seen a positive return since then, as the broader equity market has dropped:

Source: Seeking Alpha

With the new year underway and investors facing a heightened level of volatility, I wanted to do an update on BKT to see if this product still makes sense given our current climate. After review, I believe BKT remains a good buy at these levels despite its recent move higher, and I will explain why in detail below.

Agency MBS Are Less Volatile Than Other Fixed Income Sectors

When reviewing BKT, it is critical to discuss the overall health of the U.S. housing market, as well as my outlook for agency MBS in particular. This is because this sector is essentially all BKT holds, with agency MBS exposure coming in over 96%, as seen below:

Source: BlackRock

With this in mind, I am going to focus this review on why I continue to like agency MBS as an asset class, and specifically why I favor it over non-agency MBS, as well as other fixed income sectors.

One key reason is volatility or lack thereof. I see this as an especially relevant point right now, as U.S. equities have been selling off due to global growth worries related to a spreading coronavirus. With risks like this impacting the market, many investors are flocking to safe-haven assets to weather the storm. While most fixed-income sectors offer a reasonable hedge against equities, agency MBS are particularly less volatile, as shown below:

Source: Charles Schwab

*Note: This graph represents annualized returns and standard deviation from the past decade

My takeaway here is this is a great area to get exposure to if one is looking to de-risk their portfolio right now. While returns have been lower in the agency MBS space compared to other assets like corporate bonds (whether investment grade or high yield) and municipal bonds, the lower level of volatility may be just what investors are looking for as geopolitical risks rock the market. Of course, there is a trade-off, but I see this sector providing peace of mind and a reasonable return for investors in the months ahead.

I Prefer Agency Over Non-Agency Due To Risks Forming In Housing Market

My next point discusses why I prefer agency over non-agency MBS. On the whole, I have a bullish view for the U.S. mortgage debt sector right now. Improving employment figures, rising wages, and low levels of delinquencies tells me that this sector will hold up well in 2020 and presents little risk of capital to investors who own the debt. I don't see an environment in the short-term where mortgage defaults rise meaningfully, so I believe investors will do reasonably well with housing-related credit in the year ahead.

With this in mind, I would not fault investors with a higher risk tolerance for moving down the credit quality ladder to earn a higher yield with non-agency MBS at this time. However, for investors primarily concerned with reducing volatility and taking risk off the table, I would absolutely favor agency MBS right now. The reason behind this is there are some ongoing developments that could pressure mortgage bonds going forward, making me more cautious on the sector than I was last year. While I believe in the long-term story of housing bonds across both credit types, I see agency MBS as a way to protect against any potential downside if these risks impact the market.

One of the risks I am referring to is in regards to home prices. After years of rising property values across the country, annualized gains in the sector are starting to flatten out, as shown in the graph below:

Source: Bloomberg

As you can see, the gains are getting harder to come by. Keeping this in perspective, we have to recognize that home prices are at historically high levels, and I do not see flattening prices right now as a major risk to the market. However, rising home values give homeowners an added incentive to pay off their debt, as they want to stay current on an appreciating asset. Seeing values flat-line, or even decline, removes some of that incentive, which could influence delinquency rates. Again, I don't see this as a major risk right now, but it is something to keep an eye on, and makes me favor the higher quality agency MBS at this time.

A second reason has to do with housing starts, which have seen a sharp uptick recently. In fact, housing starts are now at their highest level in over a decade, as shown in the graph below:

Source: Yahoo Finance

Of course, this is not a "bad thing", and it represents confidence in the U.S. economy as a whole. Further, it signifies a healthy housing market, since home builders are willing to take on new construction. However, my takeaway here is that we are likely to see an increase in mortgage bond issuance, assuming the majority of these housing starts go to buyers who take on debt to purchase them. While I expect demand to be fairly robust for housing bonds this year, given their strong underlying fundamentals, the increase in supply will limit price gains in the sector. In fact, it could have a negative impact if demand does not rise correspondingly as high. Therefore, I see this as a sign to be a bit more prudent and focus on agency MBS for now.

Housing Fundamentals Are Strong

While I did just touch on some broad risks to explain why I favor agency MBS right now, I want to reiterate that the underlying conditions in the U.S. housing market are quite strong. Therefore, while I favor agency MBS right now, I see relative safety across the space. For support, consider the recent mortgage delinquency figures, which broadly declined in October on a year-over-year basis, as shown below:

Source: Core Logic

My point here is this is a credit market that investors can consider with plenty of confidence, as delinquency rates continue to improve quarter after quarter post-recession. Furthermore, the underlying debt looks attractive on a risk-adjusted basis, when considering current spreads. While absolute spreads for investment-grade corporate debt are higher (compared to Treasuries), those spreads have been narrowing in the short-term. By contrast, mortgage bond spreads are actually higher now than where they stood at the beginning of both 2018 and 2019, as shown in the graph below:

Source: Charles Schwab

My takeaway here is, when considering trading history, mortgage debt is in a fairly attractive position. Delinquency rates are falling, and spreads have not been tightening. This is likely due to the fact that investors have shunned safer assets over the last few years, as the risk-on rally has dominated. With volatility coming back to the market in force, the relative safety of the U.S. housing market may draw in more investors now, and current delinquency rates and yield spreads suggest it would be wise to do so.

Refinancing Risk: Very Real, But BKT Can Withstand It

While my thesis so far has been quite bullish, I am obliged to point out one of the key risks facing MBS as a whole at the moment. While the strength in the U.S. housing market is a positive catalyst, central bank movements over 2019 and 2020 has put downward pressure on mortgage interest rates. In fairness, this can be a positive for the sector. It generally supports an uptick in lending activity, and lower interest payments make mortgage obligations less of a burden for borrowers. This in turn can improve delinquency rates, which is a net win for investors in the debt, such as through BKT.

However, there is a downside to lower rates as well, which is primarily related to prepayment risk. While lower rates can improve a borrower's ability to pay, which is positive for debt holders, it could also incentivize existing borrowers to refinance. Essentially, homeowners would retire their current mortgage by borrowing at the prevailing (lower) rates to pay off their balance. This prepayment risk impacts debt holders because they will be receiving their principal back sooner than anticipated, resulting in a loss of part of the interest income stream.

This is an important risk that debt holders always face, but it is especially relevant during periods of declining rates, because that is when it makes the most sense for borrowers to refinance. And this is precisely the environment we are in now, as interest rates declined broadly in 2019 and then again this past week in the new year. This has led to a spike in refinancing activity, which sits near a five-year high, as shown below:

Source: Mortgage News Daily

My takeaway here is this reality is likely to continue in 2020, as more homeowners look to refinance. Even though interest rates are not expected to move much lower from here, refinancing activity has been gaining momentum in the very short-term, making further activity fairly certain.

The impact to BKT is that the distribution rate will probably feel the pressure going forward. If the debt within the fund is paid off early, and management elects to buy up new issuance to replace it, that new debt is going to carry a lower interest rate on average, which will pressure income production. Therefore, even though the underlying assets will be performing well, BKT and funds like it are likely to face income cuts as we move deeper in to 2020.

While this is bad news, I still believe BKT will hold up well. The fund's use of leverage allows for a yield near the 7% mark. If the income is cut modestly, say by 5% or 10%, the yield will still be very attractive, especially on a risk-adjusted basis. Further, the fund's valuation, which I will touch on in the next paragraph, should help limit the fallout from a distribution cut. Therefore, while I see this as a very real risk that investors need to monitor, it does not deter me from recommending BKT at this time.

Final Point - Valuation Is Attractive

While my primary reason for liking BKT has to do with its underlying holdings and the strength of the mortgage sector, there is another important reason why I prefer it to the multitude of alternative funds out there. This is BKT's valuation, as the market price sits at a healthy discount to the fund's NAV. With equity markets still sitting at historically high levels in terms of earnings multiples, and with many fixed-income CEFs sporting expensive premiums, BKT's discount looks attractive. Further, due to NAV growth, the discount has actually grown since my last review, even with a rising share price, as shown in the chart below:

BKT's NAV - November	BKT's Market Price - November	Discount To NAV - November
$6.36	$6.02	-5.35%
BKT's NAV - Current	BKT's Market Price - Current	Discount to NAV - Current
$6.51	$6.13	-5.84%

Click to enlarge

Source: BlackRock

My takeaway here is quite positive. I would likely be bullish on BKT at a valuation at par, but the current discount definitely sells me on this product. With many of my favorite PIMCO CEFs sitting at premium prices that make me a bit uneasy, BKT has a solid discount that allows investors to buy in to the underlying assets for less than their fair value. This is a compelling story.

Bottom Line

With volatility roaring back, I am focusing more on quality fixed-income sectors. With declining delinquency rates and strong price gains in the housing sector over the past decade, I feel agency MBS is a relatively safe place to park cash for now. While refinancing activity and a projected rise in issuance are concerns, I like BKT's high yield and attractive discounted market price. Therefore, I remain long this investment in 2020 and would recommend investors give BKT serious consideration at this time.

Analyst’s Disclosure: I am/we are long BKT. 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.