Host: Welcome, JP Gagne, senior portfolio manager at both Thrivent Limited Maturity Bond Fund and Thrivent Government Bond Fund for Thrivent Asset Management. Talking about investing in mortgage credit in these days of lowering interest rates. So, let’s start with looking at how history has shaped the investing picture today, JP.

Gagne: Well it's great to be here today. First we have to go back to the global financial crisis and look at what residential lending and investing looked like before and after. There were heavy losses [for] both homeowners and investors coming out of the crisis due to very high leverage and a dramatic drop in prices. So, I like to think about three main factors that led to the massive losses and the fixes that we've corrected in the 2.0 version.

First, appraisals. There were many conflicts of interest, and they were very easy to attain pre-crisis. Originators and banks were incentivized to get these loans out the door and were therefore very willing to get any type of appraisal. And the appraisers were incentivized to meet the bank's demands for what the level would be. Post-crisis, we don't have that issue.

Now, all originations for mortgages have to go through a nonaffiliated third-party appraisal. Therefore, the bank isn't involved in the transaction. And if anything, the bank is using technology like Redfin and Zillow to double check on the appraisal. So, if the level of looks too far off versus what Redfin or Zillow might say on the property, they can go back and ask for an adjustment.

The second main factor is really adjustable rate mortgages. 50 to 60% of non-government guaranteed mortgages prior to the crisis were adjustable rate. What that does is it really impacts budgeting and can surprise both the borrower and the lender. The borrower suddenly has a payment that is much higher than what they originally expected, due to an increase in rates, and therefore has a difficult time budgeting if they don't know what their payments are going to be every month. How do they factor in with their income every single month what they're going to be paying. So, we fixed that post-crisis, where now over 90% of mortgages are fixed rate and they're primarily 30 year mortgages. So, what that allows is borrowers know exactly what their payments going to be for the next 30 years, and lenders can verify their income and decide whether or not they can appropriately make the payments on those mortgages.

The third factor, which I think is probably the most important, is the down payment and the leverage on homes. Prior to the crisis, there was very little required as far as a down payment on a house. You could borrow up to the full value of the homes in a lot of cases. And the originators and the banks basically viewed it as there's no expectation that home prices were going to go down.

So, why not lend pretty much the entire value of the mortgage or of the, of the home? And going back to those appraisals, a lot of times those appraisals were fluff, so they were lending not really knowing what the house was actually worth. So, when prices went down dramatically, they went underwater very quickly. So, post-crisis, the big change now is that we require pretty much 20% down on almost any mortgage that's originated.

There's very few exceptions. Sometimes for first time homebuyers and such, but for the most part there's 20% equity in the home to start. Therefore, the borrowers are less likely to walk away. And the banks have a little bit of a cushion in the case that home prices do go down a little bit.

The fourth factor, which I sort of merge them together, it's the combination of second liens and second homes. Pre-crisis, you were able to continue to essentially lever up your home where you could continue to take out second liens as home prices went up, and take out all the equity in the home and keep it as highly levered as possible. And in addition to that, banks were willing to lend for a second home or a third home or fourth homes in some instances without really verifying any income or the ability to actually make a payment on any of those mortgages.

It was purely speculative with the idea that home prices were going to go up and they would be taken out at a much higher price. That is not the case now. It's really rare to borrow beyond that original 20% equity. There are second liens, but typically you have to have your home price go up by enough where you just lend back to that 20% equity and not go over.

And secondly, second homes are typically investor homes now, where they have to have some sort of confirmation that you actually can earn rental income or that you're going to be able to VRBO or something of that variety with the home. And it's not speculative. Which takes us to the fifth factor, which is time horizon.

Pre-crisis, it was all speculative. The intention was to flip the home. You weren't going to be in the home for many years, so you really didn't care if you could make the payments. Now, if you're buying an investment property, a second property, the idea is you are going to be in this home for a long period of time.

And if it is an investment property, they're going to make sure that you can verify the income that you're going to receive on a rental property. And if it is a fix and flip, which are somewhat common these days, you have to put your actual own money or own equity into the house and add value to the home that way, rather than just, relying on home prices going up.

So, all of these factors have really been addressed, as you can see in the 2.0 version of the residential mortgage market, which has helped borrowers and investors. In addition to these factors, investing is a lot less risky. Added structural support and additional triggers in the structural support to seniors in the case of a downturn has really protected investors.

So, we shouldn't see the same losses that we saw coming out of the global financial crisis.

Host: JP we've seen the headlines. The housing market is tough right now to say the least. So, how is that affecting investing in mortgage credit.

Gagne: Well it's sort of interesting because the investing industry is not feeling the same impact from the housing market that, say, new home buyers are facing. The biggest problem for current home buyers is affordability. The main three factors that are really driving this are home price appreciation since COVID, you know, coming out of COVID, everyone was upsizing pretty much leaving their apartments, their rental units, their condos and moving out to the suburbs and adding more space. There was going to be a work from home. People didn't have to make those commutes. For all those reasons, home prices went up dramatically.

Second, there is a real lack of supply. There's a lock in effect on current homeowners where anyone that purchased a home even going back prior to 2021 or 20, had the ability to either refinance or buy a new house at a really low mortgage rate.

Those homeowners aren't looking to sell their homes. If you're locked into a really good mortgage rate, it's really difficult for you to sell that and buy a new home at a much higher rate.

And that leads us to the third thing, which is mortgage rates, where right now they're still around 6%. So, it's much more expensive to buy a home than to say it was just a couple of years ago.

And for new home buyers, they're looking at it and talking to their friends and realizing that they have 2 or 3% mortgages on their homes, and they're looking at a 6% and saying, man, I really hope mortgage rates come back down. So, those are the three things that are really impacting affordability. And these issues really don't have the same impact, on credit of residential mortgage investing, because outstanding mortgages right now have a very strong credit profile.

The economy is strong, unemployment is low, and there's plenty of equity in the homes due to home price appreciation. And as we discussed, the tight lending standards where everyone basically has 20% of equity in their homes as down payment. Therefore, there's no major risk to home prices going down so dramatically that you're going to lose out on your home.

And lastly, the distressed home inventory is down dramatically. Coming out of the global financial crisis, there was over 8 million homes in the country. They're either going through the bankruptcy or foreclosure process and going through potentially short sales. That inventory is down now to less than a million, and most of those homes will probably be sold at much higher prices and where the loans that are outstanding on them.

So, therefore, there's really little risk to seeing true losses to the senior bonds on any residential mortgage bond. The difficulty for the whole space right now is just projecting turnover. As noted earlier, with 75% of the market having a mortgage of 5% or lower, there's very little sales and therefore a lot of the outstanding bonds that we see out there will have slower pay downs.

This will change, obviously, if mortgage rates do come down. And as investors, we have to manage the risk of pay downs coming in much faster or much slower than expected.

Host: You mentioned mortgage rates. How will lower mortgage rates affect mortgage credit investing?

Gagne: Well, first I think there's a little bit of a misconception in the market on the relationship between interest rates, the Fed and mortgage rates. A lot of people see the headlines and expect that as the Fed cuts, which they did in September 50 basis points that will pass through directly to mortgage rates. So, if they cut 50, mortgage rates go down by 50, or the Fed really only has control over short term bank borrowing rates, which in usual times will have an impact on all the interest rates.

But that's not always the case. On the other hand, mortgage rates are really dependent and correlated to where 10-year treasury rates are, and we might be in one of those markets where even though the Fed is tightening, we may see less of an impact on 10-year rates. The U.S. Treasury curve, which we define as two-year rates compared to where 10-year rates are, has been inverted or basically flat for a few years now, which historically is pretty rare.

Thus, the more likely outcome is that 10-year rates don't come down as much and mortgage rates with it won't drop as much. Therefore, the 6% where current mortgage rates are might be more of a long term expectation for homebuyers. So, how does this impact our investing? Well, as I said earlier, 75% of borrowers currently have a mortgage below 5%. Thus, for the majority of the mortgage market, even though rates have come down almost 150 basis points from their high, they're still not able to refinance their current mortgage.

So, really, there's this big bifurcation in the market where you have recent home buyers. Over the last year or two, they locked in mortgages that were 6, 7, 8, 9% that are looking to already refinance their mortgages. But on the other side of that, you have the majority of the market with still very low rates that are going to probably be locked into their homes for a much longer period of time.

Thus, for the pools of mortgage bonds we are buying, we really have to be cognizant of the underlying mortgage rates. In particular, Thrivent Limited Maturity Bond Fund, where the focus is avoiding any bonds which can be much longer than expected, we have to make sure that we're not going to deal with any of those extensions.

So, for the low mortgage rate bonds, we are most concerned with housing turnover. While those higher mortgage bonds were concerned with how quickly all these homeowners will refinance their mortgages, and thus how quickly we'll get our money back into potentially a lower yielding market.

Host: So, why invest in mortgage credit now?

Gagne: I can think of three main reasons for investing in mortgage credit right now. The first is credit itself. We continue to have—when I say we, the United States—continue to have a massive housing shortage, ever since the global financial crisis, we as a country have been underproducing new homes, relative to new household formations. That means we have too few homes for too many families.

I've seen estimates of the shortage anywhere between a few million to upwards of 8 million homes that we are short in this country. Therefore, home prices are on very stable footing and although we could see some correction, lowering home prices, they're unlikely to drop dramatically.

Second, spreads are yields. Levels are still very attractive both in the agency and non-agency mortgage space. Investors can earn a higher spread and/or yield in mortgage backed bonds by taking on the prepayment risk. But with so much of the market as I discussed so far out of the money from refinancing, it's much easier right now to predict how these bonds will pay down over time versus many other moments in history.

And lastly, ratings. Rating agencies continue to be really conservative with their ratings. They're still risk averse from their experience during the global financial crisis. Therefore, they require much higher support and much stronger structures for residential mortgage bonds than we believe they really require. Rating agencies rate bonds as if we were going to see something even worse than what we saw 15 years ago. And we think that's an extremely low probability.

So, in the end, I believe mortgage credit is very well supported by housing, is still offering attractive spreads and are conservatively underwritten.

Host: So what are your fears as a mortgage credit investor?

Gagne: The biggest fear I would have is interest rates dropping faster than expected due to a harder economic landing, leading to much higher unemployment. I think unemployment and interest rates are going to go hand in hand in the current economic environment. So, the Fed will have to continue to cut rates if we see unemployment rise substantially. And this impacts the mortgage credit investor in two ways.

First, with lower rates would come faster prepayments or paydowns. This would mean investors would get stuck getting money back from their bonds faster than expected, and would have to reinvest that money at lower yields. Second, and more importantly is if unemployment is spiking—when I say spiking, I mean doubling the current state, so right now, we’re around 4, low 4%—if it goes to 8, 9, 10%, we will have to see home prices start adjusting down.

As people become unemployed, they're more likely to need to sell their homes or they can't afford their mortgage payment. Or they may need to just take out equity of their homes to cover expenses until they find their next job. And furthermore, if there's a large population of the U.S. that's unemployed, there are fewer home buyers.

So, if unemployment does go that high, we could see a large supply of homes hit the market as demand for homes is also dwindling. In addition, if people have less confidence in the job market, they're also less willing to put down the required savings to purchase a home. So, as you can picture, this is a snowball effect.

And the housing market will just have to adjust lower if we actually see this. And both of these instances, as a mortgage credit investor, we would suffer as we would either be earning a much lower yield than expected, or we'd be taking potential losses on our investments due to home prices going lower.

Host: So, how do you balance out the positives with the risks in your investing practice?

Gagne: Balancing risks with potential gains is really the art of portfolio management, in my opinion. At Thrivent Asset Management, we have three funds that feature mortgage backed securities: Thrivent Government Bond Fund, Thrivent Income Fund, and Thrivent Limited Maturity Bond Fund. And each of these funds has a slightly different focus when looking at the mortgage backed space.

Thrivent Government Bond Fund focuses almost exclusively on government guaranteed bonds. Thus, the fund invests only in agency mortgage backed securities within the residential sector. These bonds have the highest liquidity other than U.S. treasuries in our market and carry no credit risk.

Thrivent Limited Maturity Bond Fund has a different priority. The Fund focus is on shorter maturing bonds. Therefore, we focus our investing on avoiding any potential extension risks due to slower turnover or slower refinance activity. As investors, we can target our investing typically in Triple-A bonds, which remain shorter in almost all scenarios.

Lastly, Thrivent Income Fund will invest in mortgage backed securities, typically for two reasons. First, as a diversified risk option versus investment grade credit or high yield credit. Or second, when the relative value against U.S. treasuries make mortgage backed securities look attractive. In late 2023, mortgage backed securities traded near their widest levels we have seen since the global financial crisis.

So, across most Thrivent funds, we increased our allocation to agency mortgage backed securities. Those spreads have tightened throughout 2024. Thus we've sold down some of our positions. In the end, our priority when investing in mortgage backed securities is protecting our principal investment and maintaining liquid positions. Over time, that has proven to add real value to our portfolios across Thrivent fund families.

Host: JP, thank you so much for your time and your insight. That was JP Gagne, senior portfolio manager at Thrivent Asset Management. I'm Erin Real and you're watching Asset TV.