Housing Is Expensive … But Mortgage Bonds are Cheap

I’m in the market for a house, but I’ve never had much luck in real estate and today’s market gives me pause. The last house I bought was a little starter home in Wauwatosa, WI for about $210,000. That was in 2003. Ten years and one financial crisis later, I sold that house … for $210,000. Add in the expenses in upkeep and improvements over a decade and it was most certainly a losing investment.

But timing is everything, and when I look up my little house on Zillow today, I see a “Zestimate” of $382,000, not a bad 10-year return for the couple who relieved me of the burden of homeownership.

Had I kept that home and rented it out, I might be more optimistic about real estate values today, but as it stands, I personally find it hard to pull the trigger on a new home in today’s housing market.

Despite the highest mortgage rates since 2008, house prices haven’t fallen much. Inventory is low, with many homeowners unwilling or unable to part with the 3% mortgage rates they locked in post-pandemic. This has kept competition strong, and cash buyers are still willing to pay a premium.

Some have called it the least affordable housing market ever. The blue line (left hand scale) in the chart below shows that housing payment-to-income ratios have skyrocketed alongside the higher mortgage rates shown in red (right hand scale). It now takes 34.2% of median household income — $2,256 — to make monthly principal and interest (P&I) payments on the median-priced home purchased with 20% down using a 30-year fixed-rate mortgage.

Price-to-income ratios have exceeded 30% before, notably in the runup to the Great Financial Crisis, and throughout most of the 1980s, when interest rates were much higher than today. I don’t know if the aftermath of this housing affordability problem will look more like the slow return to normalcy we saw in the booming 1990s or something more dramatic like 2008, but as one who makes a living looking for relative value, I’m searching for a better entry point.

If You Can’t Buy, Lend

In contrast to the rich valuations in housing, our fixed-income team believes that one of the better opportunities in today’s bond market is the residential mortgage bonds that help finance most of the houses we all live in.

When a person finances the purchase of a house with a mortgage, the lender often sells the mortgage on the secondary market to an investment bank or government-sponsored enterprises (GSE) such as Fannie Mae or Freddie Mac. These entities package the mortgage with a pool of other loans and issue bonds with the mortgages as collateral. Investors buy these bonds for the steady stream of income that results from homeowners paying their principal and interest and the strong credit protection provided by the loans’ government backing.

Today, valuations in the mortgage bond market are broadly appealing. Mortgage investors can pick up about 0.55% in yield above comparable maturity U.S. Treasury bonds. This compares to the average yield pickup of about 0.39% since 2010. For the statistically inclined, this represents one standard deviation above the average, meaning that mortgages have only been cheaper relative to Treasuries about 16% of the time since 2010.

One headwind to mortgages in a low interest rate environment is prepayment risk – the risk that homeowners prepay their mortgages by refinancing into lower rate mortgages. As rates fall, investors may receive their principal back earlier than expected and need to reinvest at lower rates. But with so many homeowners locked into low interest rates mortgages already, only about 2% of homeowners would benefit from refinancing if mortgage rates fall by half a percentage point.

The average dollar price for agency mortgage-backed securities (MBS) is currently around $89 (par value is $100), with yields in the 4.5%-5% range. The combination of wide spreads, low dollar prices, and elevated yields provides the opportunity for strong total returns in our view.

Portfolio implications

We believe that the cheapness in today’s mortgage market is a result of elevated interest-rate volatility as investors try to anticipate the course of Federal Reserve policy, and quantitative tightening as the Fed pares back its substantial holdings of agency MBS. These headwinds may take some time to abate, but unlike the valuation signals from the housing market itself, the signals from the bond market suggest mortgage bonds represent great value at today’s prices.

We have sought opportunities to add to government mortgage-backed securities in managed portfolios as part of our focus on increasing credit quality ahead of a possible recession.

Seek Advice

Timing markets is hard, as my experience with housing shows. Today, investors are adjusting to the highest interest rates in 14 years, with meaningful implications for both investors and homeowners.

Whether you are planning for retirement or looking to purchase a home, talking to a professional will help you make the best decision for you and your family. If you haven’t revisited your financial plan in the past year, now is a good time to speak with your advisor. If you are in the market for a new home, talk to one of our mortgage lenders about your options.

As for me, I’m still enjoying the view of Lake Michigan from my apartment while waiting for the right house to come along.