With tight valuations, quantitative tightening and rising rates, fixed income investors have to navigate an evolving but ostensibly challenging landscape. For investors seeking an alternative fixed income risk, exposure to residential mortgage credit offers opportunity, but is not without its own set of challenges. Although the Bloomberg Barclays Aggregate Index has a sizeable exposure to agency-backed residential mortgages, sources of other securitized credit risk are underrepresented. Credit Risk Transfer (CRT), a relatively new and growing market segment provides investors a reliable source of otherwise elusive access to residential mortgage credit exposure. As the CRT market approaches its fifth birthday, we take a closer look at the evolution of this increasingly important market segment.
Credit Risk Transfer in a Nutshell: What are Government Sponsored Enterprises Trying to Accomplish?
In the wake of the 2008 financial crisis the Federal Housing Finance Agency (FHFA) outlined a strategic plan to reduce the risk posed to tax payers from Fannie Mae and Freddie Mac. As part of this plan, a primary challenge emerged: how to reduce risk to the U.S. tax payer and the financial system, but do so in a way that preserves efficient and reliable borrower access to mortgage credit. To assist in meeting this challenge, the Credit Risk Transfer (CRT) securitization market was created.
After years of planning and consultation with capital market participants and regulators, CRT issuance commenced in July of 2013. Both Freddie Mac and Fannie Mae issued publicly registered securities, via Structured Agency Credit Risk (STACR) and Connecticut Avenues Securities (CAS) transactions. With the successful issuance of these fixed income instruments, the GSEs effectively purchased protection against
potential default risk from their mortgage borrowers via capital markets investors. The GSEs continued to collect their normal guarantee fees from lenders for covering borrower credit risk, but now compensated investors in STACR and CAS transactions for taking portions of that same risk.
How Has Credit Risk Transfer Evolved?
The concept of credit risk transfer is not new. Before the 2008 crisis, GSEs selectively used “front end” forms of credit protection tools such as primary mortgage insurance and mortgage insurance pool policies. The more recent “back end” efforts to transfer credit risk are different for two primary reasons: scale and structure.
While CRT transactions have evolved since 2013, all of the offered securities have been structured as uncapped 1-month LIBOR-based floating-rate securities. Securities pay interest and return principal monthly, mimicking the payments made by the underlying reference pool through time. Although the details vary by transaction, generally the GSEs are required to buy back the notes at par in 10-13 years and have the option to call the transaction at 10% of the original balance.
Different flavors of credit risk have emerged as investor acceptance of the CRT market has increased. Examples include transactions collateralized by borrowers with higher loan-to-value mortgages (i.e. >80%), transactions that pass through actual losses on resolved foreclosures (as opposed to prescribed loss severities) and sale of a portion of the first loss risk position. Future developments are likely to include regular issuance via vehicles that qualify as real estate mortgage investment conduits (REMICs), in an effort to increase investment sponsorship from REITs.
As the legacy portion of the non-agency RMBS market shrinks, credit risk transfer enables investors to maintain allocations to residential mortgage credit (Figure 1).
Source: SIFMA, Bloomberg. Data as of 03/31/2018
With its growing market presence and attractive characteristics, CRT is an important sub-sector of a broader securitized allocation. We continue to believe that broadly diversified securitized credit strategies warrant a “through-cycle” allocation in portfolios. Tactically adjusting allocations across the full securitized spectrum based on the most attractive opportunities and perceived relative value at any given time creates the potential for consistent outperformance as market conditions change during and through market cycles. We believe that CRT, as it continues its evolution and continues to grow, can potentially provide investors with a reliable option in this pursuit. Happy 5th Birthday CRT!
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
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