The mortgage-backed investment behind the financial crisis is in trouble again. One market expert explains the new risk, and how to sidestep painful losses.
- The mortgage-backed securities at the core of the 2008 financial crisis are facing an all-new risk, according to Colleen Denzler, an investor at Smith Capital and the former global head of fixed income at Janus Henderson.
- As bond yields slide, investors in MBS are stuck in a negative feedback loop that could further exacerbate the drop to historic lows.
- Denzler recently discussed with Business Insider her views on this asset, and how investors can mitigate the risks therein.
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The rush to buy Treasurys continues unabated and is keeping bond yields near historic lows.
Trade-war concerns have been the big catalyst of this decline, which occurs when bond prices rise amid spiking demand. Meanwhile, investors are staying away from risky assets that could see huge downside if there's a recession and rotating into more dependable investments like US government debt.
But behind the scenes, a sizeable corner of the bond market is contributing to this slump as its investors hedge their own set of risks.
It is none other than mortgage-backed securities, the bundles of homeowner debt that played a tragic role in exacerbating the 2008 financial crisis. The problem, at the time, was that these securities bundled too many mortgages that banks approved for subprime borrowers who would eventually struggle to make their monthly payments.
These days, the issue with mortgage-backed securities is more technical than fundamental. But that does not mean their ripple effects are not being felt far beyond their territory.
"They're in trouble right now," said Colleen Denzler, an investor at Smith Capital and the former global head of fixed income at Janus Henderson. Smith Capital's Total Return Bond Fund, which is comanaged with Alps Advisors, has gained 11% over the past year and outperformed 94% of its peers in that period according to Bloomberg data.
The precipitous drop in bond yields is to blame for the trouble in mortgage-backed securities.
Whenever interest rates slump the way they recently have, existing homeowners can take advantage by refinancing their mortgages. This essentially involves exchanging a current mortgage for a new one with a lower rate and cheaper monthly payments.
The problem with this scenario for Wall Street is that as homeowners give up their old loans, investors in the said mortgage-backed securities get their principal back earlier than expected.
In the process, they lose out on returns they would have earned if homeowners held on to their mortgages for longer, and the overall duration of their portfolios is shortened.
The risk of this two-fold loss is known as negative convexity. It is so paramount right now that investors are hedging against it by buying Treasuries to make up for the removal of longer-term debt from their portfolios.
Buying Treasurys is the standard response for MBS investors wanting to hedge - except that bond yields fall further when demand and buying rise. And so, what should be an uneventful hedge has created a vicious feedback loop: historically low yields increase the need to hedge, which leads to more bond buying that suppresses yields even more.
"What's happening right now is hurting because when you have those extreme moves, they're just not beneficial to how the securities are structured," Denzler said.
The vicious cycle could persist for a while
The fierce rally in bonds, which has set off recession signals and been called a bubble by other experts, could continue unabated. Even if there were to be a quick fix to the trade war, Denzler sees the US-China conflict as a longer-term issue.
"Bubbles get popped when things turn around either through some sort of crisis or through a change in what caused them," she said. "This could be a while, and that's how we're positioned."
She added that she is underweight mortgage-backed securities. She also advised investors to be wary of index products that track the broader fixed-income market.
"In equities, it's great," Denzler said of buying index funds. "In fixed, you're baking in all the biggest risks - and people don't have a sense of that."
For example, she said, companies with the most debt also have the biggest credit exposure in the benchmark Bloomberg-Barclays aggregate index. This means they could face the most strain in an economic slowdown, depending on the soundness of their balance sheets.
The SPDR Bloomberg Barclays US Aggregate Bond exchange-traded fund tracks the benchmark index, and mortgage-backed securities comprise roughly 27% of its holdings - the largest share besides Treasurys.