While one risk to the sector is a Fed that views a terminal rate closer to 6%, and thereby increasing the amount of rate hikes over the second half of the year, a second risk is a resurgence of bank stresses, which may force additional selling into the market. Currently, we do not believe either of these risks is high-probability, but as always, it depends on the data.
That said, the cushion within agency MBS remains ample, particularly when compared to the corporate market. At present, the current coupon MBS spread is about 165bps to the Treasury curve versus the BBB corporate spread of 155bps. While the consensus for a later recession has kept investors leaning toward corporate versus mortgage credit, we think this will begin to shift given the relative value within the mortgage sector. In fact, the market has started to see some shift in allocation and an increase in demand from money managers and hedge funds. We look for volatility to decline in 2H23 as the higher-for-longer narrative has now been priced in, and the reaction function of the market to the Fed’s outlook is more closely aligned.
Higher mortgage rates have not turned into the impediment originally anticipated. While mortgage rates have risen to a 20-year high (7–7.3%), the issue of affordability or lack thereof has been the headline of the year. With rebounding home prices, we anticipate this will continue to be a headwind to relocations and refinancings, given that over 65% of mortgage holders currently hold a mortgage rate of 4% or below. The combination of limited inventory, strong labor market, and unprecedented buildup in homeowner equity currently trumps the issue of affordability, in our view.
We remain with the most preferred allocation in agency MBS, with a bias toward higher coupon.
We await better entry points to the non-agency and CMBS markets, with the expectation that slower growth into 2H23 may cause some spread volatility. Although corporate credit spread, such as high yield, is now a paltry 397bps, and both high yield and IG corporates are rich relative to non-agency MBS and CMBS, for now we are sticking with the higher-quality AAA MBS sector.
While headwinds are priced in, particularly with lower-rated CMBS in the 900bps spread area, the credit crunch in commercial real estate is not fully behind us as banks pull back on lending. With office space representing roughly 30% of private label CMBS, not all will encounter refinancing issues, as only 20% of those are backed by floating-rate loans which are currently feeling the rise of incremental defaults, while the remaining 80% continue to have high debt service coverage ratios. Most of the private label CMBS market (70%) consists of multifamily, lodging, industrial, and retail, which are not poised to experience a credit crunch as the economy slows.
However, headline risk remains a greater issue, particularly highlighting the growth in interest-only loans. These are loans where borrowers make only interest payments during the life of the loan, with the entire principal due at the end. Typically, owners pay off the debt by obtaining a new loan or selling the building. With borrowing costs on the rise and lending standards tightening, it has become a point of concern.
If interest rates stay at these heightened levels for an extended period, certain sectors of the CMBS market will face continued headwinds, which may trickle over to other CMBS sectors that have strong fundamentals. Due to these potential risks, we await a better opportunity in the second half to adjust our neutral allocation.
Read the full report Fixed Income Strategist—Midyear outlook: Anticipation 13 July 2023.
Main contributor: Leslie Falconio