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By Mike Rupp
Record supply is pushing non-qualified mortgages and credit risk transfer to multiyear wides, even as fundamentals remain very strong.
The non-agency mortgage market has started the year like many other risk asset classes, with spreads materially wider. Macro concerns and geopolitical risk are pressuring spreads across credit, but the distinctive reasons pushing spreads wider in mortgage credit are extension concerns and record levels of supply. This presents opportunities to ease into mortgage credit at multiyear wide spreads.
Supply in mortgage credit was around $50 billion in the first quarter, which was the strongest quarterly issuance since the Global Financial Crisis. Net supply on the year is expected to be upwards of $60 billion versus $6 million in 2021. This negative supply technical is likely to keep new issue spreads wider for some time. In contrast, fundamentals in housing continue to be strong and, in our view, should lead to better long-term performance. Mortgage rates are climbing, and affordability is being stretched, yet lenders continue to impose conservative lending standards that keep mortgage pools healthy. Historically low inventories should keep a floor on house price movements even as rates rise. Ultimately, as mortgage rates increase, origination should slow and this supply technical should dissipate.
On-the-run agency credit risk transfer presents several opportunities. First, for shorter investment grade-only portfolios, the M1 tranche is now trading at SOFR plus 200, versus as tight as SOFR plus 85 in December of last year and at SOFR plus 75 prior to COVID—typically for a 1.5-year single A/BBB-rated security. Second, the M2 tranche, which is primarily investment grade, is now trading at SOFR plus 310. The equivalent was trading at SOFR plus 165 in December of last year and SOFR plus 185 prior to COVID. These are typically four- to six-year bonds, with greater extension risk versus the M1. These both provide attractive carry with limited interest rate duration.
For AAA-oriented investors, new issue non-QM offers the widest-trading AAA securities in residential mortgage credit. Non-QM first-pay bonds are now trading around swaps plus 175. In September, these were trading at swaps plus 85. Issuers are adding structural enhancements such as step-up coupons and sequential structures to limit extension and entice investors to buy bonds. There is less liquidity in the non-QM universe, so we believe sticking to the most liquid A1s is the best way to play this sector.
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