That so many Americans have a mortgage is in large part due to the creation of three U.S. government agencies: Fannie Mae (created during the Great Depression), Freddie Mac and Ginnie Mae. While each has a specialty, their common purpose is simple: facilitate home ownership.  

While banks traditionally provided the bulk of home loans, the agencies listed above largely assumed this role and funded the loans by issuing mortgage-backed securities (MBS). As such, MBS holders are—in simple terms—providing the capital for America’s home mortgages. But in addition to arranging the loans and issuing MBS, the agencies offer a compelling incentive to MBS buyers: As quasi-government entities, they effectively guarantee the mortgage payments will be passed through to the MBS holders. As such, the securities they issue carry the same credit ratings as U.S. Treasuries—the U.S. government’s AA+ credit rating.

Today, there are around 40 million home mortgages in the U.S. and the agency MBS market is the second largest bond market in the world, behind only the U.S. Treasury market. The MBS market is larger than the investment-grade corporate bond market and more than twice as large as the municipal bond market.¹

However, the agencies only provide “conforming” loans—loans that met certain criteria such as specified debt-to-income or loan-to-value ratios. Unsurprisingly, demand for financing from borrowers who didn’t fit within these parameters grew, and a non-agency mortgage market grew with it.

Investors typically refer to non-agency mortgages as the mortgage credit market because MBS without the agency guarantee means investors are taking credit risk—the risk that a borrower doesn’t make interest or principal payments. In this respect, the mortgage credit market is similar to the corporate bond market (also called the corporate credit market), insofar as buyers must similarly evaluate the risk that a company fails to make its debt payments.

The mortgage credit market includes commercial mortgage-backed securities (CMBS) issued to corporations for office space or other commercial purposes, as well as a variety of other loan types that are collateralized by property. But residential mortgage-backed securities (RMBS) are the largest sector of the mortgage credit market and contain many subsectors. Jumbo loans, which are loans issued in amounts above the agencies’ limits for conforming loans, is the largest subcategory at around 60% of the RMBS market. But the category also includes home equity loans, residential transition loans (RTLs), which facilitate buyers looking to renovate and resell a home, and non-qualified mortgages (non-QM), which are issued to borrowers who may have non-traditional income, a credit score below the agencies’ floor or some other mitigating factor.

The outlook for residential mortgage credit

The primary fundamental factors which drive residential mortgage credit risk are strong in the current environment, supported by a resilient economy and consumer, improving home affordability as interest rates continue to fall and a persistent shortage of homes. Additionally, home equity (the amount of the home a borrower owns) levels have grown as homeowners pay down their mortgage and been helped by rapid price appreciation. Finally, we believe the credit rating agencies have been conservative in assessing RMBS credit risk while current yields are at attractive levels and the sector continues to offer compelling diversification benefits when held within a larger fixed-income portfolio.

Home prices have a solid foundation

A soft landing for the U.S. economy combined with low unemployment are supportive for home prices. Homeowners are more likely to slow consumer spending before delaying mortgage payments, and consumption has demonstrated remarkable strength through the economic slowdown. Furthermore, the share of disposable income required for mortgage payments has plummeted over the last 15 years.

Within this more supportive environment, the U.S. continues to have a significant shortage of housing stock while demand has been accelerating. The construction of new homes plummeted during the Global Financial Crisis (GFC) and while it has slowly recovered, the significant drop in construction in the decade between 2007-2017 created a shortage of housing that has yet to be filled. While more new homes are now being built, significant excess housing has to be built to make up for the lost decade in home construction.

Meanwhile, demand has been increasing with steady population growth, migration within the country, more people working from home and a rise in homes purchased for investment. These factors aside, the current pace of new household growth (the formation of families looking to purchase a home) has outpaced even the current building rates. Simply put, the U.S. has too few homes for too many families.

Finally, the combination of extremely low interest rates pre-pandemic and the subsequent aggressive interest rate hikes after the pandemic, have incentivized many homeowners to stay put, enjoying low interest payments while steadily building home equity. A recent report by the Federal Housing Finance Agency shows that approximately 86% of home mortgages have a mortgage rate below 6%.² As such, a homeowner looking to move, upgrade or even downsize, could face significantly higher mortgage costs for a similarly priced home.

Looking ahead, lower interest rates typically lead to lower mortgage rates, improving home affordability, which is supportive for home prices. However, mortgages are generally longer-dated, 30-year loans and thus mortgage rates tend to follow longer-dated Treasury yields, not the U.S. Federal Reserve’s (Fed) policy rate, as shown in the figure below. Should longer-dated Treasury yields stay elevated on continued concern over U.S. fiscal policy and its effect on inflation, significantly lower mortgage rates could be delayed even if the Fed cuts steadily over the next year.

Rating agencies have become more conservative

The mortgage credit market allows investors to choose exposure across the credit spectrum, from the highest AAA rating all the way down to high-yield, or sub-investment grade rated credit. Like the corporate bond market, investors often rely on—and sometimes question—the quality of these ratings when making investment decisions.

Before the GFC, many home buyers were allowed to finance 100% of the price of their home while so-called NINJA (no income, no job) loans became synonymous with corporate malfeasance. But after the GFC, rating agencies generally chose to take a more conservative approach when assigning a credit rating to mortgage credit products. Today, the due diligence, credit enhancement, loss protection and third-party oversight provided by many of these securities may result in the opposite of malfeasance: an abundance of caution.

Mortgage credit yields are attractive

Because mortgage credit products do not carry the guarantees provided by agency mortgages, the yields offered are typically higher. But compared to similarly rated bonds in the corporate bond market, the yields in mortgage credit offer a compelling alternative to these same corporate bonds.

Moreover, because both mortgage credit and corporate bonds offer yields higher than Treasuries to compensate for the additional credit risk, they could see higher returns if the underlying Treasury yield falls. While lower Treasury yields could be delayed, the probability of realizing these higher returns has increased since the Fed began to cut interest rates.

MBS and mortgage credit have provided compelling returns and diversification

As the figure below shows, agency MBS have a lower correlation to U.S. stocks than the highly diversified Bloomberg Global Aggregate Bond Index, and less than half the correlation of investment-grade corporate bonds. Because agency MBS carry the same credit rating as U.S. Treasuries, the benefits of the lower correlation in MBS over corporate bonds comes with less credit risk, not more.

Like agency MBS, the mortgage credit market offers both low correlations to other asset classes while producing compelling risk-adjusted returns. As can be seen in the figure below, over the last 10 years the total return of mortgage credit has, at near 4.5%, been similar to the total return of the high yield (sub investment grade) part of the U.S. corporate bond market, but with an investment-grade rating.

Additionally, the volatility of returns in the mortgage credit market has been less than both investment-grade corporate bonds and agency MBS. These higher returns with lower volatility have resulted in mortgage credit delivering better risk-adjusted returns over the last 10 years than agency MBS, U.S. Treasuries, investment-grade and high-yield corporate bonds, and the S&P 500 Index.³

Active management suits MBS investing

As an asset class, agency MBS tend to outperform corporate bonds during and after periods of high volatility, as can be seen in the figure below. This provides opportunities to add value through asset allocation decisions, particularly after periods of stress that can produce weakness in other credit markets.

But opportunities can also arise as fundamental or more technical factors evolve. For example, in late 2023, agency MBS were trading near their widest levels since the GFC largely due to banks reducing their mortgage holdings to improve the quality of their balance sheets. (Mortgages are long-maturity assets while banks fund themselves with short-maturity cash deposits). This was an investment opportunity for those who shared our view that prices were being skewed by a temporary technical factor and would revert higher as supply and demand normalized.

At the industry and security level, mortgage credit offers more opportunities in sectors, subsectors and individual structures than can be found in the corporate bond markets. Each mortgage credit product could have different underlying loan types, borrower credit scores or levels of borrower equity. For example, one product may be similar to another on all of these factors but contain more geographical diversity, making it a preferable investment for investors seeking greater diversification. Finally, credit ratings can lag changes in underlying risks, offering potential for outperformance as the rating agencies catch up to the fundamentals. 

Given the advantages active management may provide, we encourage investors interested in mortgage credit to consider actively managed funds which can invest in the asset class. For example, Thrivent Limited Maturity Bond Fund (THLIX) invests primarily in shorter maturity AAA-rated securities, and thus can add highly rated mortgage credit to its investment portfolio, helping to boost the portfolio’s yield without sacrificing credit quality. Similarly, Thrivent Income Fund (LBIIX)—which seeks to generate more income than U.S. Treasuries by investing in other highly rated securities—invests in mortgage credit to potentially provide additional yield and to help diversify the fund’s exposure to corporate credit risk.

While mortgage credit can, in our view, be an attractive addition to a variety of diversified fixed income portfolios, investors may wish to consult with a financial professional to determine how investing in the asset class may align with their particular long-term goals and objectives. 

Media contact: Callie Briese, 612-844-7340; callie.briese@thrivent.com

Thrivent Limited Maturity Bond Fund – Risks: The value of mortgage-related and other asset-backed securities will be influenced by the factors affecting the housing market and the assets underlying such securities. Debt securities are subject to risks such as declining prices during periods of rising interest rates and credit risk, or the risk that an issuer may not pay its debt. These and other risks are described in the prospectus.

Thrivent Income Fund – Risks: Debt securities are subject to risks such as declining prices during periods of rising interest rates and credit risk, or the risk that an issuer may not pay its debt. High yield securities are subject to increased credit risk as well as liquidity risk. U.S. government securities may not be fully guaranteed by the U.S government and issues may not have the funds to meet their payment obligations. The value of U.S. government securities may be affected by changes in credit ratings, which may be negatively impacted by rising national debt. The value of mortgage-related and other asset-backed securities will be influenced by the factors affecting the housing market and the assets underlying such securities. These and other risks are described in the prospectus.

¹ All market size data from Securities Industry and Financial Markets Association (SIFMA), as of December 2023.

² “FHFA Releases Data Visualization Dashboard for NMDB Outstanding Residential Mortgage Statistics” Federal Housing Finance Agency. July 2, 2024. https://www.fhfa.gov/news/news-release/fhfa-releases-data-visualization-dashboard-for-nmdb-outstanding-residential-mortgage-statistics. November 14, 2024.

³ Source: Bloomberg. Data as of July 31, 2024.