Remember when nobody wanted to touch U.S. subprime-mortgage debt? That's just a distant memory as they deliver some of the bond market's best returns.
The securities that were created in the years leading before the financial crisis in 2008, the last time such notes were issued, have gained almost 12% this year, or six times more than junk-rated corporate debt, according to Barclays Plc. After contributing to the collapse of Lehman Brothers Holdings Inc., bonds tied to the riskiest home loans have returned 75% since 2010, topping speculative-grade corporate debt for three straight years.
The rally in the U.S. home-loan securities stands in contrast to corporate-debt markets, which have buckled as oil prices plunged and the Federal Reserve moves toward raising benchmark interest rates from close to zero. With the economy poised to grow at the fastest rate in a decade and home values rising for a third year, subprime investors are being rewarded as the wave of foreclosures on the worst loans subsides.
"A lot of the uncertainty around the asset class has been taken away," Tom Sontag, a money manager at Neuberger Berman Group LLC, which oversees about $250 billion, said by telephone from Chicago.
While almost 30% of the subprime mortgages tied to bonds are at least 60 days delinquent, the percentage has fallen from as much as 41% in 2010, data compiled by Bloomberg show. In the broader market for mortgage securities without government backing, which also includes loans known as alt-A and jumbo debt, the default rate has fallen to 23% from 30% in 2010.
The share of borrowers falling behind payments for the first time has dropped for at least three straight years, while the amount of delinquent homeowners who are able to catch up without getting their loans changed has risen in each of those years, according to Nomura Holdings Inc.
That's helped yields, after accounting for projected principal losses, on some types of subprime securities to fall 0.5 percentage point since June to 5.8% even as prices on other debt slumped, according to Bank of America Corp.
For junk-rated companies in the bond market, borrowing costs surged to an 18-month high as oil prices plunged below $60 a barrel for the first time since 2009. Yields on speculative- grade corporate bonds soared to 7.5% on Dec. 16, from an all-time low of 5.69% in June, according to Bank of America index data.
Dwindling supply has also supported values of so-called nonagency mortgage bonds. Since the crisis, issuance has been limited to a small slice of the safest big home loans and pools of soured or once-delinquent borrowings. The amount of nonagency bonds has fallen to less than $720 billion, from more than $2.3 trillion in 2007, according to Fed data.
"It's going away, there's a dedicated buyer base and there's strong fundamentals," said Carl Bell, the Durham, North Carolina-based deputy chief investment officer at Amundi Smith Breeden, the U.S. unit of the money manager that oversees more than $1 trillion globally.
Rising home prices have also decreased the number of borrowers who owe more than their homes are worth, which reduces the risk that they may just walk away from their obligations. Less than 17% of homeowners have mortgages that were under water in the third quarter, down from as many as 31.4% in 2012, according to online real estate advertiser Zillow Inc.
U.S. economic data is also showing continued strengthening as small-business surveys point to more workers on the cusp of bigger wage increases, said Tom Porcelli, chief U.S. economist at RBC Capital Markets LLC.
"The data has been uniformly positive," Porcelli said at a Dec. 12 press event in New York. Lower fuel costs will also bolster consumer spending, he said.
Gary Singleterry, an investment director at Swiss money manager GAM Holding AG, who specializes in mortgage- and asset-backed securities, said there's value in nonagency bonds partly because he can invest in securities with floating yields that stand to benefit when the Fed raises rates.
More than 90% of purchases made this year by his firm's about $500 million of mortgage-focused accounts have been of debt without government backing, he said.
The subprime bonds have also rallied as hedge-fund managers speculate on the likelihood that lenders will make payments after misrepresenting loan quality. Investors also may get reimbursements from other parties to deals such as trustees, which are being sued on more 54% of all transactions from 2004 to 2008, according to a report by Deutsche Bank AG.
