by David Schawel, Economic Musings
Halloween was a fun time in our household this year, our four year old was finally old enough to have fun, dress up, and eat a lot of candy! As is probably typical in other offices throughout the country, many of my colleagues brought in leftover Halloween candy and the office collectively made ourselves sick on chocolate.
By the second day the large bowls had largely been picked through and only the least desirable snacks remained. Reese’s Cups & Snickers were long gone. As I stood over the bowl I began to try and convince myself that the remaining “bad snacks” could still be good.
Although it’s a stretch of a comparison, the same type of feeling is now present in the fixed income markets. The low hanging fruit has been picked. Years of income have been pulled forward through rapid capital appreciation. Yields and spreads have come in substantially. We are no longer in the early innings where easy money was made across the credit universe in high yield, non-agency MBS, IG Corps, levered loans, and so on. The relentless buying of Agency MBS has pushed investors into spread products and thus richened almost all areas of the bond market. Smart money has adapted and is now forced to become more selective. A good example is Ellington Financial (run by Mike Vranos) which said the following in their earnings release today:
In the third quarter, the market for non-Agency MBS rallied significantly. As home prices continue to stabilize (and are even trending higher in many regions), and as mortgage default rates continue to decline, investor demand for non-Agency RMBS has continued to increase. Meanwhile, alternatives for higher yielding investments in those other fixed income sectors where investors typically search for higher yields, such as Agency RMBS and investment grade corporate bonds, have become more limited, thereby further increasing the demand for non-Agency MBS. With interest rates currently at historically low levels, many financial institutions (such as pension funds and insurance companies) are finding that they will be unable to fund their long term liabilities without increasing their allocations to higher-yielding asset classes; we believe that this state of affairs will continue to provide support for the non-Agency MBS sector.
Later on Ellington discusses how they became less constructive on non-agency MBS and have found great opportunities within CMBS. Vranos isn’t the only renowned MBS manager to recently take a liking to CMBS. As I discussed in a recent post over at Inside Investing, DoubleLine’s Jeffrey Gundlach has also made a move into CMBS.
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