For a European investor, US mortgage bonds are a great diversifier—and can offer attractive yields too. But with the US economic cycle so extended, will they make a great investment? We believe there are several reasons why US mortgages can be a resilient core holding for European investors’ portfolios.
The US mortgage bond market is as different as can be from mainstream European bond sectors. It’s not just distinct in terms of geography and politics, and in economic and credit cycles. It also depends on a more diverse range of assets and issuers. Instead of relying on the balance sheet of a government or corporate entity, investors in residential mortgage-backed securities are relying on the personal balance sheets of hundreds of thousands of US homeowners. Of course, the solvency of those homeowners is geared mainly to the US jobs market and US wage levels. That makes US mortgage bonds less sensitive to the risks that are obsessing European (and global) investors—notably, Brexit, political turmoil in the euro area, the slowdown in China and other threats to European economic growth—and generates truly non-correlated performance, in our view.
With total debt outstanding of US$8.1 trillion,* the US residential mortgage-backed securities market offers extraordinary depth and variety in terms of size, number and risk/reward profiles of its constituent securities. It also offers investors a choice between fixed-interest bonds and floating-rate notes, in the form of credit risk transfer, or CRT securities. In addition, the market provides attractive yield. Net of hedging costs for a European investor, a diversified US mortgage portfolio with an average investment-grade (IG) credit quality can currently offer a yield of about 2.0%.** That compares with European IG corporate yields of about 1.2% and government bonds yielding near 0%.
Risk and Reward
The median price of a US single-family home has risen just over 40% since the last housing-market crash. While newspaper headlines about a slowdown in the US economy and housing markets may put some on edge, our analysis indicates a gradual slowdown, not a bursting bubble. That’s largely because inventories remain tight and future demand looks healthy. And with no recession in sight, we believe US mortgages represent a useful addition to European investors’ bond portfolios.
All About Affordability
Housing affordability declined in 2018 because of higher home prices and rising mortgage rates. However, housing affordability is a function not only of mortgage payments but also of income, which has been rising as the economy continues to chug along. Over time, this should help to moderate the negative effect of higher mortgage payments.
Furthermore, the decline in housing affordability hasn’t been massive. Homes are still more affordable than they were between 1999 and 2003, which was a healthy period in the housing market. And, of course, expectations of future US rate rises have moderated considerably in 2019.
Millennials to the Rescue
While supply is supportive of home prices, we believe that demand will remain supportive too.
Population demographics will help the market over the next few years. Many millennials are approaching the age of a first-time home buyer. Of course, not all of them will want to buy a home. But even if the millennial generation purchases homes at a lesser rate than previous generations, it will translate into a significant increase in demand, thanks to the generation’s sheer size.
Given these various outlooks for affordability, supply and demand, we expect home prices to continue to rise over the next few years—albeit at a slower pace. We anticipate US home-price growth of 2% to 3% versus the 6% rate of the past several years.
Mortgage Sector Remains Attractive
For investors in bundled residential mortgage debt—whether agency-issued mortgage-backed securities (MBS) or CRT securities—there is yet another fundamental factor to be considered: average borrower quality.
Borrower quality for these types of debt reflects not only a robust labour market—marked by both high employment and rising wages—but also very strict underwriting standards. That was not the case in 2006 and 2007, when many borrowers had no job, no income and no paperwork.
With no correction in sight for US housing, investors who shy away from the US mortgage market today may find themselves regretting the lost opportunity before long.
Sources: Bloomberg, AllianceBernstein
*As of 31 December 2018. Source: SIFMA (US Securities Industry and Financial Markets Association)
** As of 31 January 2019. Assumes a diversified US mortgage portfolio investing in CRT, agency and non-agency mortgages, and commercial mortgage-backed securities. Yield of 2.0% is derived from portfolio yield-to-worst of 5.1% in US dollars minus 3.1% cost of hedging US dollars into euros.
For investment professional use only. Not for inspection by, distribution or quotation to, the general public. Current analyses do not guarantee future results.
