In focus

Housing bonds: Opportunities in a unique corner of the muni market


Housing finance agencies (HFAs) assist with financing for low to moderate income families to enable them to purchase affordable housing. HFAs issue both single family and multi-family deals, however, most of the market is single family. At Schroders we primarily focus on the class of bonds with a planned amortization schedule (Planned Amortization Class bonds or PAC bonds), most of which come to market as part of a single family transaction.

These bonds are typically secured by whole loans or mortgaged-backed securities guaranteed by Ginnie Mae, Fannie Mae or Freddy Mac, or a combination of these. Because of the strong legal provisions and solid backing these structures offer, they typically skew to the higher end of the credit-quality spectrum. This begs the questions: Where do the opportunities exist in this market and what differentiates issuers?

What differentiates the credit quality of various issuers?

Financial position

  • Balance sheet strength: A program’s asset to debt ratio is crucial in assessing balance sheet strength. Higher quality deals typically come structured with asset levels in excess of liability levels; this is considered over-collateralization. This mechanism of over-collateralization shores up the balance sheet of the program, which bolsters investors’ confidence in the credit.
  • Cash flow/profit margins: Cash flow projections are critical to the asset and liability management (ALM) of a program. Those credits that demonstrate the ability to service debt and maintain a strong program-asset-to-debt-ratio (PADR) under various stress scenarios are deemed strong credits.

Loan portfolio

  • Portfolio performance: Portfolio performance can be determined by a number of factors but the key factors we look at are delinquency rates and defaults across loan portfolios. While broad macroeconomic factors may cause systemic patterns of delinquencies and defaults that affect issuers across the US, idiosyncratic patterns may emerge among muni mortgage-backed security (MBS) issuers that can be identified through relative analysis of defaults and delinquencies across various issuers.
  • Portfolio characteristics: Portfolio characteristics can vary. Some of the key characteristics we look at are types of loans, backing of the loans and whether the loans in the portfolio have any secondary backing such as mortgage insurance. Average loan-to-value (LTV) of the portfolio is also important with lower LTVs being a credit positive for HFA bond investors.
  • Local real estate market: Another important factor to consider
    is the local real estate market: how the market has been performing and whether we anticipate stable or volatile real estate valuations in that particular jurisdiction. Numerous factors can drive the quality of a real estate market including the interest rate environment, but also factors more specific to each local economy including intermediate-term economic changes and secular trends such as demographic and migration patterns.

Bond program structure

  • Variable rate debt: The level of variable rate debt in the bond program can be an important factor in the ALM of the overall program. Typically, mortgages are fixed rate loans that provide income to the program at a fixed dollar amount over the life of the mortgage, so higher levels of outstanding variable rate debt can introduce an ALM mismatch. Should rates materially rise, program revenues may not be enough to sufficiently service variable rate debt that resets at a higher rate. We therefore view programs with a higher percentage of variable rate debt outstanding as a risk factor when looking at deals. Because of this dynamic, many HFAs do manage this risk using interest rate swaps or other interest rate hedging strategies.

Environmental, social and governance (ESG) factors

We conduct a comprehensive ESG analysis of all our issuers including HFAs. One way we do this is by using our proprietary ESG analysis tool MunEx. MunEx integrates quantitative and repeatable methodologies into our credit selection process. Equally important is analysis from a qualitative perspective, particularly as our analysis relates to governance factors; the quality of financial reports, frequency of changing auditors and timeliness in financial reporting are all examples of factors that we study.

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Example: North Carolina Housing Finance Authority

Contraction and extension risks
One of the key considerations when investing in the MBS market is contraction risk. Earlier than expected prepayment of capital can leave investors with dry powder in an environment with low-return opportunities and can cut short an investment with expected high coupon rates. This can affect overall returns for the lifecycle of an investment plan. Conversely, extension risk can also be important as an investor can lock up capital in a rising rate environment, costing the investor opportunity in a higher return on capital (ROC) marketplace and could be especially concerning if coupons are low.

When we invest in PAC bonds, we look at the various prepayment speed scenarios and the corresponding impact on the average life of the bonds and therefore the yield and spread that can be achieved in each scenario. The probability we ascribe to each prepayment speed scenario has numerous implications for the way we manage our portfolios including duration and curve management, overall portfolio spread, and yield and sector concentration measured by DTS (Duration Times Spread).

The example shown in Figure 2 is a North Carolina PAC bond that we purchased at the beginning of 2021. The issue price was $110.637 with a 4% coupon and optional call in 2029. The table of Public Securities Association Standard Prepayment Model (PSA) speeds with various average lives is what is referred to as a “PAC collar.”

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As you can see, if the optional call is exercised (right-hand column), which would be economically rational for the issuer to do if the price remained above par before 2029, then assuming a 0% PSA (no prepayments in the pool of loans), the average life is nine years, meaning that all principal will be paid back in 2029. The most extreme scenario in the other direction would be if PAC bond rates rose prior to 2029, causing the price of the bond to decline below $100, therefore causing the optional call to be out-of-the-money (OTM). In a 0% PSA scenario, this would extend the average life of the bond to 27 years since it would not be economically rational for the issuer to exercise the OTM call option. Optically, it may appear that extension risk is quite significant, but the originators of these deals do publish and commit to a payment schedule alongside their PSA scenarios that they try to adhere to. While this is not a legally binding schedule, it is in the interests of the originator to keep as close to the schedule as possible in order to retain credibility among institutional PAC bond investors. If issuers deviate too significantly from their promises to investors, their ability to raise capital in the future may suffer significantly. Typically, a PAC deal is structured in such a way that cash flows from other tranches in the program may be repurposed to an extent in order to keep payments in line with the PAC bond payment schedule. Therefore, the extreme average life extensions outlined in the PSA scenario table – while possible – are unlikely given the backstops and incentives in place. The same goes for extreme contractions in average life. Deals are structured in such a way that other support tranches absorb prepayments to protect PAC tranche investors from average life uncertainty.

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Schroders MBS PAC bond process

Schroders methodology for managing PAC bond exposures

At Schroders we proactively monitor the average lives of our PAC bonds in real time and employ proprietary methods to determine how far the deviation is between the planned average life at issue and the actual running average life according to how actual payments have played out.

While this enables us to actively manage our duration exposure to a more precise degree, it also helps us assess whether spread or yield levels are accurate and fair from a portfolio execution perspective – we may discover that bids or offers are mispriced according to our proprietary methodology and the fair value it enables us to determine.

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We tackle muni MBS investment using a multi-faceted approach. Our team of dedicated credit analysts continually evaluates changing fundamentals of issuers and ensures that they are well prepared to issue investment recommendations on the fly. At the same time, our portfolio managers and traders manage exposures and make investment decisions using an array of tools, including the PAC average life monitor. Through the use of proprietary tools, quantitative frameworks and collaborative working, we believe we offer our clients a comprehensive service in helping them navigate and invest in this sector.

Our view of the HFA MBS market as of Q2 2022

Housing bonds generally provide additional spread to compensate investors for any uncertainty regarding how quickly homeowners will pay off their mortgage and because investors demand a premium for liquidity. Specifically, within the housing sector, we identify value in PAC bonds due to the fact that their structural features reduce the likelihood of early principal payments and price more like shorter dated securities. We therefore believe PAC bonds will continue to perform well.

Incremental spread in the sector compensates investors for some of the unique characteristics of the market, including potential early redemptions, a liquidity premium and idiosyncrasies of the sector. PAC bonds provide more prepayment certainty, usually with a predetermined prepayment schedule. Because of these unique features, housing bonds rated AA and A provide an average extra yield of 11 to 35 basis points over similarly rated revenue bonds, according to an analysis by J.P. Morgan.

As markets stand on the precipice of rising rates, volatility abounds. Historically housing bonds have performed well in rising rate environments. In the last four municipal outflow cycles, housing bonds outperformed the overall market. Looking at the data from 2020 (global pandemic), 2018 (period of rising long-term Treasury yields), 2013 (the Taper Tantrum) and 2010 (Meredith Whitney’s prediction of “hundreds of billions of dollars” of municipal bond defaults), we see the housing sector perform well against other sectors of the market.

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Conclusion

In this tight spread, yield-starved environment we look to build a portfolio with safe carry. We continue to focus primarily on 100% agency-enhanced PAC bonds. The relatively higher yields of housing bonds and their propensity to trade less frequently could reduce the securities’ volatility; they also may provide incremental spread.

 

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.