Normally Trouble, Refinancings Are Boosting Some Mortgage Bonds

(Bloomberg) -- When homeowners refinance their mortgages, bond investors often get hurt, but a small corner of the debt market is ironically benefiting from it.

The debt in question, known as credit risk transfer deals, are issued by Fannie Mae and Freddie Mac, and unlike most U.S. mortgage securities now, when homeowners start to miss payments it is the investor who bears the losses. CRT bonds sold starting in 2018 have a little-known feature that can mitigate those losses, and high levels of mortgage refinancing over the last year have helped trigger that provision.

The “supplemental subordinate reduction amount,” which was added to entice potential investors, makes it so payments can pick up even if delinquencies remain high, according to Mark Fontanilla, whose eponymous company created the CRTx Credit Risk Transfer Return Tracking Index. In these deals, once an existing CRT’s size is big enough compared with the unpaid balance of its reference pool, principal payments will resume despite any failed delinquency tests.

Refinancings have been happening fast enough to trigger this provision. Last month, three Fannie Mae CRT deals saw relatively large principal paydowns on the tranches that are first to be paid when mortgages are refinanced, representing about 8% to 10% of their unpaid balance, while one Freddie Mac deal saw about 5%, according to Fontanilla.

The resumption of principal cash flows has helped the lower-rated tranches of deals with the SSRA perform better than the rest of the CRT sector since November, Fontanilla said.

This restart of payments can be a boon when bond yields are rising, and the U.S. Treasury 10-year yield has been on a slow upward trend since August. Increasing yields may soon pull mortgage lending rates higher, too.

By allowing principal payments to resume despite elevated delinquencies, the SSRA provision helps reduce extension risk on those specific CRT deals that have it, according to Chris Helwig, a managing director at Amherst Pierpont Securities.

“If delinquency rates remain elevated, this feature may become increasingly valuable,” he said.

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