Hedge-fund manager Chris Hentemann has found what he calls his favorite deal of all time.
Hentemann’s 400 Capital Management LLC bought a new type of bond sold by Freddie Mac in July in which private investors share the risk of home-loan defaults with the mortgage-finance company. Hentemann, chief investment officer of the hedge fund, said these securities, categorized as agency credit-risk transfer securities, were “exceptional value” because they were a new asset class offering high yields with relatively low credit risk.
Investors have profited from betting on discounted non-agency residential mortgage bonds, which largely were issued to riskier borrowers before home prices collapsed in 2007 and don’t have government backing. Now that the rally in those bonds is slowing, managers like Hentemann are investing in the next iteration of mortgage bonds -- so-called non-agency 2.0 -- such as the risk-sharing debt or pools of securitized jumbo loans.
“You had a large, deeply distressed market and with the recovery-based opportunity, it didn’t take much specialization to get an outsized return following the herd,” said Hentemann, whose New York-based firm manages about $1 billion in assets. “Now the herd has thinned and the opportunities are more for the domain of specialists than drive-by investors.”
MBS connoisseurs are seeking good bets in a contracting non-agency market. It dropped to $1.6 billion in deals tied to new loans this year through April compared with $1.2 trillion in both 2005 and 2006, according to data compiled by Bloomberg.
Returns also are shrinking on non-agency mortgage bonds. Investors reaped gains of 10 percent in 2013 compared with 21 percent in 2012, according to Amherst Securities Group LP. This year through March, the debt returned about 3 percent, Amherst said.
Freddie Mac Bonds
Government-controlled mortgage-finance companies Freddie Mac and Fannie Mae have issued more than $6 billion of the risk-sharing debt as lawmakers seek to scale back their roles in the $9.4 trillion mortgage market. Melvin Watt, director of the Federal Housing Finance Agency, which regulates Freddie Mac and Fannie Mae, called for more private investment during his first public comments earlier this month.
“FHFA’s second strategic goal, reduce, is focused on ways to bring additional private capital into the system in order to reduce taxpayer risk,” Watt said in his May 13 speech in Washington. “Our 2014 scorecard requires each enterprise to triple the amount of risk transfers in 2014.”
The Freddie Mac notes are unsecured obligations rather than standard mortgage-backed securities. They are structured so principal can be erased for bondholders when homeowners stop paying their mortgages.
Western Asset Management Co., which oversees $469 billion, participated in the first Freddie Mac risk-sharing transaction in July, as well as its three subsequent offerings and the three sales by Fannie Mae, said Anup Agarwal, head of mortgage-backed and structured products at the Pasadena, California-based firm. He said he was attracted to the securities because of the shrinking legacy non-agency market, their attractive pricing and yields, and the bonds’ eligibility for retirement accounts, unlike most other non-agency securities.
Hentemann, who was head of Bank of America Corp.’s structured products unit before starting 400 Capital in 2008, said the Freddie Mac deal in July stands out because of the high quality of the underlying loans. They have average FICO credit scores above 750 and low loan-to-value ratios.
The riskiest tranche of the first Freddie Mac offering last traded at about 131.5 cents on the dollar after being priced at par, for a gain of more than 30 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
“The credit quality was the best we’ve seen since the mid-1990s,” Hentemann said. “There was a premium for being an early mover since it was a brand new market.”
The risk-sharing market has become more efficiently priced than it was a year ago. At the most recent sale last week, $1.6 billion of bonds by Fannie Mae had very strong interest relative to the amount of bonds for sale, Hentemann said.
Investing in securitized pools of jumbo loans, or those above the $417,000 limit in most areas, is also attractive because they are generally made to wealthy borrowers with high credit scores, Agarwal said.
Jumbo loans are one of the stronger parts of a shrinking mortgage market as the biggest banks ratchet up efforts to win rich clients and originate these loans. Applications for jumbo mortgages of at least $729,000 increased 4.9 percent in March from a year earlier, while requests for loans of less than $150,000 fell by 21 percent, according to the Mortgage Bankers Association. In April, purchase applications for loans of $729,000 and higher were down 6 percent from a year ago, while purchase applications for loans below $150,000 were down 21 percent from a year ago, the MBA said.
Smaller lenders that don’t have the capacity to keep jumbo loans on their balance sheets are most likely to be the sellers of those mortgages, said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication in Bethesda, Maryland.
The sweet spot for investors who are still looking to make money in legacy subprime loans are mortgages originated in 2005 and 2006, Hentemann said. Those borrowers have been making monthly payments that are more likely going toward the principal amount borrowed, he said.
Hentemann’s 400 Capital Credit Opportunities Fund returned 4.6 percent this year through April 30 and 15 percent in 2013, according to a person familiar with the returns who asked not to be identified because the information isn’t public. The most commonly used fixed-income benchmark, the Barclays U.S. Aggregate Index, gained 2.7 this year through April and fell 2 percent last year, Bloomberg data show.
Managers at Pacific Investment Management Co., the world’s largest fixed-income investor, prefer legacy non-agency MBS to commercial mortgage bonds because of better pricing for the residential securities, according to a first-quarter report for its $1.2 billion Pimco Mortgage Opportunities Fund.
Bank of America
Pimco is looking for bonds that will benefit following bank settlements related to misrepresentation of the quality of loans made, the report said. Bank of America agreed in 2011 to pay investors $8.5 billion for mortgage-backed securities sold by its Countrywide Financial Corp. unit. Bonds tied to that settlement may increase in price after it takes effect.
Notes tied to subprime loans returned 5.6 percent this year through May 27 as the housing rebound helps reduce defaults, Barclays Plc index data show. That compares with 3.1 percent for U.S. government debt and 4.5 percent for high-yield bonds, Bank of America Merrill Lynch data show.
Returns for non-agency bonds aren’t going to be as high as they used to be, said Bryan Whalen, who helps manage the $7.9 billion TCW Total Return Bond Fund at Los Angeles-based TCW Group Inc. The gains will be more attractive than in other parts of the fixed-income market, he said.
Whalen’s fund returned an annual 6.3 percent over the past three years, ahead of 99 percent of rival funds, according to Bloomberg data.
TCW is finding opportunities in the senior part of the capital structure for subprime and Alt-A loans, Whalen said. Investors aren’t being paid enough to descend into the lower parts of the tranches, he said. The firm is singling out pools of borrowers who have had consecutive years of timely mortgage payments because these borrowers will either refinance or move as home prices rise and defaults continue to decrease.
U.S. home prices increased 12.4 percent in the 12 months through March, according to the S&P/Case-Shiller index of 20 cities, the smallest 12-month gain since July. In February, the index rose 12.9 percent.
“The attractive aspect of the mortgage market is it’s a very large asset class and always has dynamic opportunities,” Hentemann said. “The opportunities for mortgage credit investors continue to evolve.”