The non-agency MBS sector has gone through a roller-coaster ride in the last few months due to heavy sell-downs by leveraged players and a subsequent snapback in demand by value hunters. We remain overweight the sector on the service due to continued sector demand, fiscal support of households and a decent housing price backdrop. In this article we review a number of CEFs that allocate to the sector. Our main takeaway is that investors should pay attention to how different funds manage their short-term rate exposure – with the PIMCO funds doing a better job of this than others. At the same time, however, the sector discount valuation is on the expensive side. This suggests waiting for a better entry point by holding defensive positions in open-end funds such as the Angel Oak Multi-Strategy Income Fund (ANGLX).
The non-agency MBS sector went through a difficult March with the market flooded from distressed mREIT sellers. Once the dust settled and the Fed stepped in to backstop parts of the credit market, demand flipped and MBS paper became hard to source leaving dealers significantly lighter on inventory and credit spreads retracing more than half of the widening. More benign than expected borrower performance also supported valuations.
Despite the slowdown in macro activity, rockbottom mortgage rates should continue to support both borrower payments as well as house prices. Policymakers also acted quickly to forestall foreclosures by implementing a foreclosure moratorium and subsequently extending it to the end of August. In addition, forbearance implementation as well as general financial household support through the CARES Act should support the performance of mortgage securities. Forborne payments are expected to be repaid by adding missed payments to the principal balance and avoiding a lump sum repayment.
Our approach to this CEF sector is driven by a number of factors. First, how well has a fund navigated the difficult March drawdown period? Secondly, what steps has the fund taken to manage its floating-rate exposure? Thirdly, has the fund deleveraged and if so, how much? And fourthly, what is the fund’s discount valuation? We discuss these factors in the sections below in more detail.
Navigating The Drawdown
A key factor in investor allocations is how different funds are able to navigate a difficult market environment. This has to do with manager skill, fund leverage, fund allocations and other fund factors. Although the recent drawdown left many income portfolios underwater, the silver lining is that funds have left a track record of how they have been able to cope with a crisis. The chart below shows total NAV returns of sector CEFs into the drawdown to the present day.
Source: Systematic Income
The chart shows a few interesting things. First, the Nuveen Mortgage and Income Fund (JLS) has outperformed over the entire period. This makes sense as the fund is positioned relatively defensively and with lower leverage.
Among the three PIMCO funds, the Dynamic Credit and Mortgage Income Fund (PCI) has underperformed which also makes sense since it entered the drawdown at the highest leverage in the sector and has cut the most leverage among PIMCO funds during this period which has limited its recovery.
The Western Asset Mortgage Opportunity Fund (DMO) has had the worst performance over the entire period which looks to be due to just a couple of days at the worst of the drawdown. This looks like the result of a deleveraging handled particularly poorly. It is less likely to be a marking down of the portfolio since we don’t see an associated remark higher in the subsequent weeks as we do for JLS.
A clue as to what may have happened is an SEC filing made by DMO L.P. (rather than the Inc. entity which makes all the regular fund filings) which shows that the fund sold $36m of securities on 25-March – a date after which the fund suffered a drop of 7%.
All in all, this picture tells us that JLS has pretty much delivered on its lower-octane premise and outperformed in this environment. Among the higher-leveraged funds, however, the PIMCO funds appear to have handled the episode more gracefully than has DMO.
Interest Rate Exposure
One of the key characteristics of non-agency MBS assets is that they tend to be floating-rate. In other words, the coupons of these securities are tied to interest rates that reset frequently, typically every 3 months. This means that when short-term rates fall as they have recently, the income levels from these securities will drop. This can be bad news for income investors who prize distribution stability.
Funds have a number of ways to mitigate this sensitivity to falls in short-term rates. First, they can hold floating-rate liabilities such as repos or credit facilities that are also linked to short-term rates so that when rates fall the funds’ leverage costs fall as well. Funds can also hold receive-fixed interest rate swaps which convert floating-rate cashflows into fixed cashflows.
Checking under the hood of the CEFs all of them appear to have floating-rate liabilities which will limit the drop in income on the asset side of the balance sheet somewhat and more so for higher-leveraged funds like the three PIMCO funds. The PIMCO funds also hold some fixed-rate securities on the order of 25-30% in the form of high-yield corporate bonds. Finally, only the PIMCO funds hold interest rate swaps in the amounts to fully immunize themselves from the drop in short-term rates.
The main takeaway here is that we should expect to see a drop in fund earnings from JLS and DMO in the coming months. Both funds have made distribution cuts in May and June so part of this is already baked in.
Leverage Levels And Trajectory
Another key factor for future fund earnings is the change in fund leverage. All five of the sector funds have deleveraged though the range is very large. JLS shed more than 40% of its borrowings while the PIMCO Dynamic Income Fund (PDI) shed hardly any at all. This suggests that PDI should be in a better position to maintain its pre-drawdown level of earnings than the other funds.
Source: Systematic Income
The final factor in the allocation decision is discount valuations. Overall, the sector is not cheap as it is trading at a 5.3% premium and a 5-year premium percentile of 58% and a 0.3 5-year z-score. The widest discount in the sector is that of JLS though this is justified given its lowest current yield. The lowest discount percentile in the sector is for DMO though the fund traded at a discount 6% wider as recently as mid-June. The PIMCO funds have also not wasted much time pushing the premiums to pre-drawdown levels and all are now trading at elevated premiums. This suggests few outright bargains.
What do all these factors point to?
There are three main takeaways. First, the underlying asset class remains relatively attractive and resilient.
Secondly, the relative discount/premium picture of the sector appears reasonable. Funds with weaker earning profiles are trading at cheaper valuations than funds with stronger earnings profiles.
Thirdly, the volatility of the sector discount/premium remains high and given current elevated valuations argues for a tactical approach to initiating positions for those investors who are not yet allocated to the sector.
Source: Systematic Income
While waiting for better entry points it makes sense to maintain an allocation to the sector via lower-volatility mutual funds particularly if investors can do it without a sales load. The chart below shows that two sector mutual funds had considerably smaller drawdowns than the sector CEFs.
Source: Systematic Income
We particularly like the Angel Oak Multi-Strategy Income Fund (ANGLX) here though we do expect its distributions to move somewhat lower in the coming months since about two-thirds of its portfolio is floating-rate. That said, it offers a decent combination of fees, sector exposure and defensive posture. Investors should be able to reallocate from it to CEFs once attractive discounts open up.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANGLX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.