What We Like In Non-Agency Mortgage Funds

The late stage of the current investment cycle suggests to us an increased allocation to fixed-income assets that rely less on the extended corporate and sovereign balance sheets. For this reason, we are drawn to non-agency residential mortgage-backed securities (MBS), which we recently split off into a separate sector in our strategic allocation framework at Systematic Income.

One reason for our increased focus on the sector has to do with the fact that this is an asset class that has begun to grow again after years of paydowns. Another reason has to do with the fact that it provides one of the few plays on the household sector of the economy rather than the corporate, commercial or government sectors at the time when consumers are in a relatively healthy shape. Thirdly, the asset class is relatively uncorrelated to other assets and has a low duration in an environment of low nominal and real interest rates.

Within the sector closed-end funds we like the Nuveen Mortgage and Income Fund (JLS) and Western Asset Mortgage Opportunity Fund (DMO) as we think these funds can close the gap with the more expensively valued PIMCO funds. Within mutual funds, we like the AlphaCentric Income Opportunities Fund (IOFAX) for its stronger historic returns and more of a pure-play sector approach. We also like the Semper MBS Total Return Fund (SEMPX) for more conservative investors for its excellent risk control as well as the lowest fee in the sector.

A Brief History Of The Non-Agency RMBS Market

Prior to the crisis a number of factors drove the creation of a large private-label mortgage security market such as sharp housing price appreciation, new securitization technology, a lax regulatory and rating agency approach as well as high investor demand for investment-grade assets.

As house price appreciation slowed down due to Fed rate rises and slowing economic activity, some homeowners and speculators faced difficulties servicing their mortgages or finding demand for their properties. MBS securities began seeing higher than expected losses which caused a wave of downgrades and forced selling by rating-constrained investors.

Prices fell below fundamental values in many instances which opened up an opportunity for active unconstrained investors like PIMCO and others to take advantage. The chart below shows the price of ABX.HE indices which track a set number of RMBS tranches with the same original rating. AAA indices fell more than 70% during the crisis and have since rebounded somewhat, stabilizing in 2015-2016 at what appears to be fully-valued levels.

Source: Markit

New issuance essentially stopped for several years after the crisis and the size of the sector decreased through defaults and paydowns. More recently, however, issuance has been increasing and has offset the maturing legacy assets so that the size of the sector has begun to grow again. New issuance rose to $24 billion in the third quarter of 2019.

Why The Non-Agency RMBS Sector Looks Attractive

We like the sector for a number of reasons.

First, the household sector looks more attractive to us than either the corporate of the government sectors. In contrast to these two sectors, households have been deleveraging since the end of the financial crisis.

Source: Angel Oak

Real wages have been growing as the labor market has remained tight with unemployment at extremely low levels. This, combined with low interest rates, means that household financial statements have rarely looked better in the last few decades.

Source: Angel Oak

The second reason we like the sector is for risk and diversification reasons. The non-agency RMBS sector registers by far the lowest pairwise correlation to the other sectors on our strategic allocation framework. The average figure for the other sectors is 20% while the non-agency RMBS sector registers a reading of zero. This means that the sector does not tend to co-move with the other income sectors, providing valuable diversification.

The chart below captures sector correlations to stocks and bonds as well as sector trailing twelve-month yields. A larger circle that is closer to zeros on both axis is a good place to be.

Source: Systematic Income Strategic Allocation Framework Tool

In addition to this, the sector registers one of the lowest return volatilities in our framework which is closer to the volatility of the agency mortgage sector, despite a significantly higher yield. Part of this has to do with the fact that few funds in this sector are pure play RMBS funds and there is some diversification baked into the allocation of the funds themselves.

Source: Systematic Income Strategic Allocation Framework Tool

If we look at the combination of yield and volatility, the sector looks very attractive. First, its yield beats the majority of income sectors and secondly, its historic volatility and drawdowns is the smallest after cash.

Source: Systematic Income Strategic Allocation Framework Tool

Evaluation Sector Investment Options

At Systematic Income we are investment structure agnostic meaning that we look across both open-end and closed-end funds, as well as individual securities, to the extent they are available to retail investors, for opportunities.

As far as the non-agency RMBS sector, investors are limited to a handful of actively managed vehicles. This has to do with the nature of the asset class which is mostly illiquid and that trades by appointment.

It is hard to draw a fine line when selecting the funds in the sector as many multi-sector funds have a sizable allocation to the sector. For example, all 9 taxable PIMCO CEFs have an allocation to the sector ranging from roughly 20% to 65%. We have settled on funds that have a majority or near-majority of their allocation to the sector.

Within mutual funds we have:

  • AlphaCentric Income Opportunities Fund Class I (IOFAX)
  • Semper MBS Total Return Fund Investor Shares (SEMPX)
  • Deer Park Total Return Credit Fund Class A (DPFAX)
  • Angel Oak Multi-Strategy Income Fund A Shares (ANGLX)

Within closed-end funds we have:

  • Western Asset Mortgage Opportunity Fund (DMO)
  • PIMCO Dynamic Credit and Mortgage Income Fund (PCI)
  • PIMCO Dynamic Income Fund (PDI)
  • Nuveen Mortgage and Income Fund (JLS)
  • PCM Fund (PCM)

Key Stats

In this section we outline the allocation percentage in the non-agency RMBS sector (which we call RMBS here for short) as well as the net expense of the fund. The allocation figure for CEFs is a bit tricky as some of the ABS securities are home equity loans which, while technically different from mortgages, can have similar underlying risk characteristics through their connection to similar type of collateral.

This information shows that IOFAX, DMO and JLS are more of a pure-play non-agency RMBS investment while the other funds are much more diversified. Fee structure also differs widely. It should be said that the mutual fund institutional classes usually have lower fees than the investor class funds included below.

  • IOFAX: 94.3% in RMBS, 1.75% fee
  • SEMPX: 92.8% in RMBS, 1.01% fee
  • ANGLX: 68.8% in RMBS, 1.36% fee
  • DPFAX: 80% in RMBS, 2.15% fee
  • PDI: 58% in RMBS/ABS, 1.89% fee
  • PCI: 55% in RMBS/ABS, 2.12% fee
  • PCM: 68% in RMBS, 1.41% fee
  • DMO: 99% in RMBS/ABS, 1.72% fee
  • JLS: 99% in RMBS/ABS, 1.37% fee

Historic Return Profile

Some of these funds started up later than others so we only have four years of data with all funds included. The chart shows us two main things: first, that CEFs have outperformed mutual funds. This is not a surprise given the combination of CEF use of leverage as well as the strong sector performance over the last few years. The second thing it shows us is that within CEFs, PIMCO funds have outperformed. This is due to a combination of more aggressive positioning, cheap use of leverage, secondary market sales of premium funds among the key drivers.

Breaking this down into annualized returns we get the following chart.

Two of the CEFs DMO and JLS have recently termed out which may change their return and risk profile. For example, over the last few months JLS has been allocated in a very conservative fashion as the fund went in and out of the shareholder vote and tender offer. It will pay to keep an eye on the fund’s risk profile as it begins its new life as a perpetual fund.

Historic Risk Profile

To get their higher historic returns, the CEFs have taken on more assets via leverage. CEF NAV volatilities are about twice as large as those of the mutual funds, with the exception of JLS whose lower volatility is skewed by the deleveraging necessitated by the process of conversion into a perpetual fund.

Since closed-end funds only typically hold 50% more assets than unleveraged funds (equivalent to a 33% leverage figure), this suggests that the assets that the CEFs hold must also be riskier in order to drive 100% of additional volatility. This makes sense if greater riskiness correlates with lower liquidity given that CEFs are not under any obligation to return investor cash at any time. This feature allows them to hold less liquid assets.

Source: ADS Analytics

Price volatility is significantly greater than NAV volatility for CEFs and on the order of 10x that of the open-end funds. This has to do with the discount trading dynamic as discounts can be quite volatile.

Source: ADS Analytics

Discount Valuation

The presence of discounts is one aspect which separates mutual funds from closed-end funds. In the current market environment of high risk appetite and low yields, the closed-end funds, with the exception of DMO, are trading close to their highs.

The discount of JLS has widened as the fund termed out which makes sense. The behavior of DMO makes less sense to us. When the fund was a term fund, it often traded at a high premium which, had the fund terminated, would have led to steep losses for holders. And now that the fund did term out, its premium fell. We would have instead expected the opposite – the fund trading at a discount closer to zero as a term fund and at a premium as a perpetual fund given its high correlation to PDI.

Over the medium term we would expect the discount differential between JLS, DMO and the other three CEFs to converge somewhat.

Yield Profile

In the chart below we plot three types of yield that we follow on the service. TTM or trailing-twelve month yields which include special distributions, current yields (equivalent to last annualized distribution) and covered yield which adjusts for distribution coverage. JLS is probably biased lower given its cashflow-based distribution program which suggests that some of its earnings is tagged as ROC.

Source: ADS Analytics

In terms of coverage, there is monthly data for the PIMCO funds. PCI and PDI have six-month rolling coverage that is still above 100% although they are on a downward trend. UNII levels are well above zero, although UNII should be used with caution for these fairly complex funds.

Source: Systematic Income CEF Tool

Takeaways

Since different investors will have different utility functions, we don’t think there is a single fund that can work for everyone. That said, within CEFs, we like both JLS for more conservative investors and DMO for more aggressive ones. We think both can close the discount valuation gap with the PIMCO funds.

Within mutual funds we like IOFAX for its more pure-play approach to the sector as well as its stronger historic returns which have bested the other mutual funds each of the last three years. For more conservative investors we like SEMPX which in addition to its good risk control also boasts the lowest fee.

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Disclosure: I am/we are long JLS, IOFIX. 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.

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