Stewart: Mortgages make up about 30% of the core bond market. It is a massive holding for most any insurance company, and we are going to have a very in-depth conversation today about the mortgage market. My name's Stewart Foley, I'll be your host, and this is the InsuranceAUM.com Podcast. I'm joined today by Jake Remley, Senior Portfolio Manager and Principal at Income Research and Management. Jake, welcome.
Jake: Thank you, Stewart. I really appreciate you having me.
Stewart: I'm thrilled to be able to geek out on mortgages with you today. I'm trying to contain my excitement. I realize that puts me in a very rarefied geek category, which is perfect for me. But before we get going too far, I want to ask you to start it off, what's your hometown, what's your first job (not the fancy one), and a fun fact.
Jake: Yeah, sure. My hometown is Newburyport, Massachusetts on the north shore of Massachusetts, very close to the New Hampshire border. My first job was in Newburyport as a dishwasher at a fancy Italian restaurant. One of the most exciting days of my life was when I was promoted to be a busboy after about a year of dishwashing. A fun fact, so I did not have my first class in finance until I was 27 years old in business school. I was an engineer prior to that. I have a lot of comfort with numbers and I think that's a big reason why I've gravitated towards mortgage-backed securities.
Stewart: That's fantastic. I think an engineering background would be ideally suited for mortgages, right? It's terrific. Man, a lot's going on in this market this year. It's incredible. I just can't wait to get into it. But, before we get going too far, what's the current environment, state of the state in the US government bond market in just straight-up govies?
Jake: Yeah, sure. The government bond market naturally has been really under a lot of pressure because of the Fed hikes relative to the inflation situation we have in the economy. We've had 15 hikes, probably going to 17 next week, and that has raised interest rates, especially on the front end. The good news is that funding markets, which are really the lifeblood of government bond markets, have been under stress, but not to the point that there's been a crisis this year. Even going back to the 2019 repo crisis, we just haven't seen that situation come up. I think that speaks to the robustness of the government bond market these days.
Stewart: I'd love to tell you this is because I'm brilliant, but it's not. We locked in a 2.85% 30-year fixed mortgage on our house a couple of years ago. I'm one of those people that is causing the extension in the mortgage market because I'm not refi-ing no matter what. But with mortgage rates reaching a 21-year high of 7.35% earlier this month, what has the impact been, or what are all the many impacts, in the mortgage market to this point?
Jake: I think you hit the nail on the head. There's been a tremendous extension of the expected cash flows from the mortgage market because of this option that borrowers have to refinance. You're just seeing that option really being so far out of the money become less valuable for those borrowers that did lock in low rates. As a result, you have really kind of a new market altogether, where a year ago that option really dominated valuations and people were refinancing.
It typically was the same set of people that were continuously refinancing lower and lower as we went down in rates over the last 10 years or so. Now, you're seeing these cash flows really act more like long agency to ventures, if you will, very out of the money on the option, dollar price is below 90, in some cases even 80 the buck relative to where they were issued at par. As a result, they're more bond-like than they are option-like at this point.
Stewart: Just for somebody who doesn't necessarily understand that jargon, when you say 80 the buck, you're talking about an $80 price bond. That's how low the dollar price of these securities has been, not through credit distress, just from the move in interest rates, right?
Jake: Exactly. These coupons that these bonds have are way below where you'd get a mortgage issue today, which would be around 6.5% to 7%. When you have mortgage pools being created off mortgages like yours that are as low as 2% to 2.5%, and we had quite a bit of those, a trillion dollars in each of those coupons over the last three or four years, that has created a very, very slow prepay environment. The prepays typically are a result of a variety of circumstances with the borrower, but the largest one is when they refinance their current mortgage into a new mortgage at a lower rate.
The other factors, like moving because you need a bigger house, or you change jobs into a different part of the country or whatever the reason is, that can also create turnover, and also defaulting, neither of which are more than maybe a handful of percent a year in any given mortgage pool. And that, as a result, has created this extension or this expected lengthening of the cash flows.
Stewart: Just to give me some numbers, I mean, you mentioned if you're a mortgage guy, you got to be a numbers guy. Can you quantify the extension just from a duration perspective?
Jake: Yeah, absolutely. When we started the year, the mortgage index was down below four years in duration and now it's up around six and a half, seven years. That extension has been driven primarily by these lower coupons. But in an overall context, when you're 30% of the Agg, it's actually cost the Agg, the Bloomberg Barclays Aggregate Index, to really extend out its duration as well.
Stewart: Before I hit the record button, we talked about convexity. Convexity basically measures call risk. The higher the number, the lower the call risk. The lower the number, the higher the call risk. Mortgages have always been traditionally a negatively convex market. You're getting paid some yield for accepting that call risk, but that's changed. What has happened to the convexity in this market from the beginning of the year?
Jake: You hit the nail in the head. The convexity was negative at the beginning of the year because mortgage bonds were so dominated by that option or that borrower's incentive to refinance As that went away and as rates went up, you had that convexity improve to the point now that it's roughly flat or zero.
It doesn't necessarily mean it's as good as like a comparable maturity Treasury bond, which typically has a positive convexity, especially as you go out further on the curve, but it is a situation that we really haven't seen before in the mortgage market where there's almost no convexity risk at this point given how far out of the money or how much higher the mortgage rate is than what most people are holding on their homes these days.
Stewart: Maybe I should have started here on this, but Income Research and Management manages core fixed income and insurance companies are a major part of your business, right? Can you give me just a little bit of background on Income Research and Management, and then I want to talk about how you're thinking about the agency MBS market?
Jake: Yeah, absolutely. I think the important aspects of our investment philosophy are that we are duration neutral, bottom-up bond pickers. We don't make interest rate bets or interest rate forecast that we embed into the portfolio. Of course, that also means that in the mortgage market, we're not projecting when rates are going to incentivize people to refinance or not refinance. We really have to take a different approach than what most mortgage bond investors are taking to come up with a concept of value or relative value, especially against bonds that don't have optionality like most corporate bonds or Treasuries, for example, Treasury bonds.
Stewart: You run the mortgage book there. How are you thinking about the agency MBS market right now?
Jake: I think from our standpoint, we need to make sure we understand what the risks are. If we're looking at all the possible paths of interest rates, especially in this economy and this environment right now, where there's a great deal of uncertainty even over the short run as to where we might end up, we have to make sure that we're not going to get unduly hurt or affected by an adverse outcome in interest rates.
I think when you look at some of the metrics that are very popular in the mortgage-backed market like OAS, which stands for option-adjusted spread, you don't get that visibility as to what paths might hurt you relative to the overall average or calculated spread that you are using when you do take OAS and compare it to, say, the OAS of a Treasury or corporate bond or other non-option laden security.
From that standpoint, we do a lot of scenario analysis and then we say, "We're not going to buy or hold the mortgage-backed bonds that have the largest amount of variance in their outcomes because that could result in an adverse result relative to non-option laden bonds where you don't necessarily have that path dependency on your returns.
Stewart: I don't know if this is center of the fairway for you or not, and you can certainly skip this question, but has the hybrid workplace or the fact that working remotely is a more of a thing, has that impacted prepayment speeds on mortgages? Is that something that is knowable, or is that something that is on your radar screen?
Jake: Yeah, I think that's a really good question because I think in part, we've seen really a white-hot housing market as a result of a variety of circumstances. One is very low mortgage rates until now, but also this change to work from home or this shift, which has precipitated, I think, folks are looking for more space, looking for maybe homes a little further away from their office because they don't have to commute five days a week, maybe three days a week or two days a week or none, no days a week. From that standpoint, I think you did see some of that embedded in the housing market numbers. And that does affect, especially these days, that does affect, as I mentioned before, the overall activity in mortgage pools because you do have an element that is people moving or defaulting, which will affect the numbers, especially now given the refinancing component is so low. And so as a result, when you do have uncertainty in the mortgage market, these days it's more about what's going on in the housing market than it is what's going on in the refinance environment, which is a very different paradigm, I think, for us collectively as mortgage bond investors to get used to.
Stewart: I think if the investment philosophy of Income Research and Management doesn't really align with how the rest of the world typically looks at an agency MBS, how are you finding ways to outperform?
Jake: I think when we approach the mortgage-backed market, we look at all the possible options. That includes the $7 trillion component that we're talking about right now, but it also includes a number of sub-sectors, if you will. Those can have better convexity or better, more stable cash flows under even more adverse interest rate environments. And that might be agency adjustable rate mortgages where you have a short period of fixed rate mortgage payments and then you float with interest rates. The advantage to the investor is that the floating portion no longer has that duration sensitivity that the fixed rate period has.
When you shorten that fixed rate period up, and it's typically 5 years and then 25 years of floating for a 30-year mortgage obligation, the duration uncertainty is reduced tremendously. And that helps us be more confident that we know no matter what interest rates do, when our cash flows are going to come in. There's others, agency multifamily or commercial real estate market, which is actually a part of the Bloomberg Barclays Agg. It's a very small part, but it is a component. It's called agency CMBS, typically.
That will have mortgages on commercial real estate, typically apartment buildings, multifamily dwellings, which are not refinanceable outside of the last six months to maturity or balloon payments. That gives us, again, much more confidence that we know what our cash flows are going to be regardless of what interest rates do. I think these other areas of the market for an active bond manager that's bottom up can be a great place to hide out when uncertainty has risen. That's typically what we do to outperform the more plain vanilla, very interest-rate-sensitive part of the market.
Stewart: Where do you see opportunities or do you see opportunities within agencies and govies? I love this conversation because I lived it for quite some time right into the GFC and then through the GFC. I've been out of this space for a long time, but it seems to me that this topic, talking about agencies and govies was dormant for years and now all of a sudden it's part of the conversation again. What opportunities do you see in those two segments?
Jake: I think that the yield environment is such that you can now get around 5% from a purely agency or government-backed portfolio. That is great because you don't have credit risk, especially given the uncertainty in the economy. That may prove to be very wise in hindsight, but you also have very good liquidity. We often talk about Treasury liquidity, but I think agency mortgages especially, given their $7 trillion+ market, are really kind of 1A on liquidity. They're very close second in the global bond market.
From that standpoint, I think you can get a high amount of yield, or an attractive amount of yield – good liquidity, no credit risk. If you're an insurance company, we've seen also a very low risk weighted capital constraint. From that standpoint, I think you can use this type of idea for liquidity pools or pools where you might need to pay claims out or otherwise have ready access in terms of having that first layer of liquidity in your bond portfolio.
Stewart: I mean, for most of these folks, I've done maybe five podcasts with CIOs in the last 60 days, and it's like they can buy two-year Treasuries and add to their book yield. I mean, that's something that was impossible for years, and so it's nice to see this coming back around. You mentioned earlier that agency MBS excess returns in 2022 have been low. I believe that you said that it had a record low of minus 400 basis points in October. Why does Income Research and Management think this sector still provides attractive relative value?
Jake: I think that the low watermark that we hit in October in the history of the Bloomberg Barclays Agency MBS Index at -400 basis points was really the confluence of two factors. One is this convexity or this extension in the cash flows that is now past us. It's now sort of the horses left the barn. We've revalued to longer cash flows. The option is out of the money. It's a different type of environment now for mortgages. It won't be affected like that going forward here. The second was the Fed balance sheet policy, which investors were really fretting over because the mortgage balance sheet has a few trillion in agency MBS on it.
And if the Fed continues to appear behind the eight ball in terms of the inflation situation, one of the tools that has been speculated they might use is active sales off the balance sheet, especially as prepayment slowed down, the caps on their mortgage runoff have been much higher than what they've actually seen on a monthly basis coming off the balance sheet. You wonder if they might speed that up by selling mortgages. We don't believe that to be the case. It is a hard one to handicap, but we do think the market priced that in pretty fully and then some. We've been buying mortgage bonds with this idea that even if it does come to fruition, it's already been priced into the market.
At the same time, the Fed has really continued to be adamant that they're not planning to sell any of their holdings and using this runoff approach is perfectly fine with them for the foreseeable future.
Stewart: Jake, you mentioned some of the sectors that you find attractive earlier. Are there other sectors where you see good relative value?
Jake: Yeah, I think there's certainly a case to be made in the government bond market for some of the agency that still issues. The SBA issues the ventures, which are backed Small Business Administration loans and they're government guaranteed, so effectively part and pass with US Treasuries. They typically trade 60 to 80 basis points off the Treasury curve. You can add additional yield and returns over time by being in these SBA ventures rather than being in Treasury bonds. We talked about agency arms. We talked about agency multifamily.
There's really a whole litany of other sectors that are not as cuspy or as volatile as agency MBS, but still provide attractive spread. You have CMOs, for example, which can be backed by the more plain vanilla agency MBS, or they can be backed by more seasoned, less volatile collateral. Volatile, I mean prepayment-sensitive collateral, which will then allow for the structures themselves to really enhance the stability. Investors can then choose within the structure where they want their effective maturity or their weighted average life to fall.
If you want a short strategy, you don't want much duration risk, you can use these CMOs and these other ideas to really create a mortgage high-quality agency or government-backed mortgage strategy, which gets you effectively the lion's share of the spread being offered in the market without the duration risk beyond say two years, for example.
Stewart: It's been a minute since I ran a mortgage portfolio and I've heard from some of my CIO friends that technology has really come around. Can you talk a little bit about the evolution of mortgage analytics and prepayment models? What has changed? Has anything changed? Can you get me current on the state of mortgage analytics these days?
Jake: Yeah, sure. I think the mortgage analytic space is helpful to a point, and you have models which will embed a certain number of assumptions, which normally in calm or slower-moving economic conditions are okay. But I think when you have a fast moving housing market that's really changing very quickly, some of those assumptions get stale before the analytics can update them. That's not that they don't want to update them, but there's more of a process for them to update that analytic and then roll it out and have it put into production. From that standpoint, I think we're a little less comfortable just relying on the analytics that we can get our hands on.
We do use them. They are very helpful for looking at relative value, especially within mortgages. But then when you start to do the relative value to non-mortgage bonds, it becomes a little bit more I think of a ‘we need to pull out what we're looking for’ from an evaluation standpoint and compare it in a very transparent and flexible way that leads us away from some of these black boxes, if you will.
Stewart: We used to have these debates. You've got mortgage duration out to three decimal points. I'm like, the only thing I can tell you with certainty is that number's wrong. I'm not sure which direction it's wrong, but it's wrong. There's a gazillion assumptions built in there and you've got to have a sense of the market. You've got to understand the market and which way... It's partially behavioral. The Fed policy certainly has an impact, but there's a lot to it. You can't just plug a number in and come up with... There's some art around this as well.
I mean, obviously your background and experience and the experience of Income Research and Management certainly comes to the forefront when you're running that kind of money. I think that's interesting that obviously, the analytics are better, but you still got to have some… Experience doesn't hurt anything when you're talking about this stuff. Before we go, I was a professor for a number of years and my heart is open to the people who are earlier in their career. As someone who's coming out of college today or has been in their seat for a year or two, I know that you've done this for a good long while, what advice would you give the 21-year-old Jake Remley today?
Jake: Yeah, sure. I would say don't be afraid to make mistakes. I think there's value in making a mistake, but learning from it very quickly. Certainly on a trading floor, you want to minimize mistakes, but they do happen. They happen to the best of us. It doesn't matter if you're young or been in the business for 20+ years like myself. From that standpoint, I think you just raise your hand, you say you made a mistake, you get help immediately. You don't let it fester or try to hope it goes away with the market.
You just have to recognize that next time, maybe you have to do something a little bit different in your approach to that trade or that investment situation. I think from when you first enter the business, it's a really scary place and it seems like everyone is very confident and moving quickly, but I think it's part of the process of becoming a seasoned investor is to be willing to make mistakes and then rectify them as fast as possible.
Stewart: Great advice. I appreciate you being on, Jake. Thanks for taking the time.
Jake: Thank you, Stewart. I appreciate it.
Stewart: Thanks for listening. We've been joined by Jake Remley, Principal and Senior Portfolio Manager at Income Research and Management. If you have ideas for a podcast, please send me a note at podcast@InsuranceAUM.com.com. My name's Stewart Foley, and this is the InsuranceAUM.com.com Podcast.
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