As the Federal Reserve contemplates three rate hikes in the coming year, bond investors are betting that U.S. homeowners will not default on their mortgages in 2018. Investors in 2017 bought relatively new bonds offered by Fannie Mae and Freddie Mac known as credit risk transfers. Offering floating rates, these bonds offer up some protection in the event the Fed does hike rates in 2018.
After the 2008 housing crisis, investors spent pennies on the dollar buying subprime mortgage bonds. Today, those investors are getting paid nearly $80 billion annually in principal repayments. Additionally, credit risk transfers in 2017 returned nearly 10 percent to investors, which outpaced the 7.2 percent returns from high-yield bonds. Analysts at Morgan Stanley estimate that credit-risk transfer debt added on top of government debt could add another 3 percent in returns in 2018.
When homeowners fail to make their mortgage payments, investors who buy credit-risk transfer debt are among the first to suffer losses. However, investors are betting homeowners will make their payments since unemployment is just 4.1 percent and the U.S. economy grew faster than 3 percent at an annualized rate.
Recent announcements by Fannie Mae and Freddie Mac also have investors believing the bonds will perform well in 2018. The two government-backed mortgage agencies announced they will sell $13 billion in CRT bonds in 2018 as part of their main investment programs.
Investors want exposure to residential credit, according to Michael Canter of AllianceBernstein, who oversees $600 million in mortgage-backed securities and other debt at the firm. They plan to accomplish this by parking their money in credit-risk transfers offered by Fannie Mae and Freddie Mac.
The two mortgage agencies began offering CRTs in 2013 as a way to put some of the risk burden on taxpayers and investors. Fannie Mae and Freddie Mac guarantee payments against default on the mortgages that make up the credit-risk transfer bonds.