Bond Market Dynamics and Home Equity Securitization Trends

Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications, and today I'm joined by Douglas Gimple, our firm's senior portfolio specialist for fixed income.

In today's episode, we'll discuss the latest developments in fixed income markets with a focus on home equity securitizations. We'll also discuss risks and opportunities for investors going forward.

Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So sit back, grab that cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.

Hi Doug. Great to have you back on the podcast.

Hi Jess. As always, it's wonderful to be here.

Let's kick things off by talking about some of the recent events and the impact that those events have had on fixed income markets. Obviously, we had the US presidential election, which was a big outstanding question prior to November, and then a few days after the election, the Fed held its regularly scheduled meeting and cut rates by 25 basis points (bps) after previously cutting 50 basis points back in September. So, I would love to get your take on why the longer end of the yield curve moved higher despite this easing and what we would call a swift result for the election.

Jess, that's a question that I've gotten quite a bit. I was on the road the last couple of weeks, and that's a question that we continually get about rates, about the Fed, especially about the longer end and how it's reacted post-September and November meeting.

But really, headed into the September meeting, the market was really split as to how much of a rate cut we were going to see. Was it 50 bps? Was it 25 bps? I would argue that if you asked a hundred people in the business what they thought, you'd probably get a pretty even split of 50/50. But once the cut was announced, the expectations were for an additional 25 basis point cut in both November and December.

The Fed then delivered that 25 basis points in November, two days after the election. But the expectations have shifted quite a bit for the December meeting with the fed funds pricing in roughly a 50/50 chance of a 25-basis point cut.

So, as you mentioned, Jess, the longer end of the curve climbed higher despite the accommodation from the Fed. Specifically, the 10-year Treasury has climbed from 3.7% after the September meeting to we'll call it 4.38% as of this afternoon, which is November 19th. Over the same time period, the 2-year Treasury moved from 3.61% to 4.28% and the 30-year increased from 4.03% to 4.56%.

There are a couple of different explanations as to why this is happening and any or all of them could be right at this point, did the markets price in a much more aggressive easing cycle before the Fed meeting and now it's adjusting? Do we now have a Fed that will be a bit more tolerant on inflation now that it feels like it's a bit under control and it is well off of its peak? And what will the election results have on the US fiscal situation and the impact of the growing deficit?

So, these questions, I think, are plaguing the market and one of the reasons that we've seen the curve move higher. Other culprits that we need to look at for this shift higher in rates would be stronger than expected economic data, such as non-farm payrolls adding 254,000 jobs in September, unemployment dropping to 4.1% from 4.2%, and now we did have a less than stellar October non-farm payroll report of 12,000 jobs added compared to the expectations of around a hundred thousand jobs, but there was quite a bit of noise in that number including two major hurricanes and a significant strike at Boeing.

November's non-farm payroll report, which will be released on December 6th, is going to be interesting is we could see some catch up from the prior month's issues. Expectations are already targeting roughly 175,000 jobs added.

And then as you mentioned, we got the surprising results from the US election. I don't think the surprise is the result itself, but the fact that it was resolved so quickly. I think the markets were geared up for lawsuits, allegations of fraud and general uncertainty if the election was close in either direction. The fact that it was over so quickly and decisively was a source of relief regardless of what side of the aisle one sits on. The Trump trade that fueled the markets was, I believe, as much about expectations for Trump's second term as it was about the definitive results that we weren't really expecting.

And Doug, let's circle back just for a minute, back to the labor market data. Obviously, it feels like we're still operating under the “data dependent” philosophy that the Fed had put out a little while ago, with September meeting expectations in terms of non-farm payrolls, but October coming in weak, what do you think investors should be focused on or thinking about in terms of the Fed's next move? You mentioned a 50/50 chance of a 25-basis point cut in December.

Yeah, as we talked about, I think there's quite a bit of noise in the October data. The drop to 12,000 jobs added from the prior number in September of 223,000 jobs on a revised basis was one of the most significant downturns this year, but the number was delivered with some sizable caveats. The Bureau of Labor Statistics referenced both Hurricane Helene and Milton in their comments on the October data, stating that payroll employment estimates in some industries were affected by the hurricanes. However, it is not possible to quantify the net effect on the over-the-month change.

So, unemployment moved a shade lower, as I mentioned, from 4.2 to 4.1%. The labor participation rate edge is a little bit lower from 62.7% to 62.6%. Historically, even with that October slowdown in non-farm payroll, the labor market's still in a pretty good place. Since the beginning of the year, using just the revised monthly payroll numbers, the economy has added 1.7 million jobs or roughly 188,000 jobs per month, and we've seen the market reflect that positioning in the pricing of Fed futures. At the beginning of October, the market was pricing in roughly 70 basis points of rate cuts by year-end over the final two meetings of the year. So that's a 25 and a 50 or a 50 and a 25. Remember, this is before the election and before the November meeting. After the 25-basis point cut in November and some stronger than expected economic news, the market's now pricing in a 59% chance of a 25 basis point rate reduction, roughly 14.7 basis points of easing in December. So that's a pretty significant shift, but reflective of the soft-landing narrative.

But your question is the biggest one at the moment. How does this easing cycle proceed? No one is saying that the Fed is stopping this easing cycle — that's not going to happen, but the velocity definitely feels as though it is shifting, as evidenced by the market expectations for year-end 2025. After the September meeting, the market was pricing in roughly 200 basis points of rate cuts by the end of 2025 for a final level of 2.88%. Today we're seeing roughly 78 basis points of rate cuts by year-end 2025 for a terminal rate of 3.79%. So, we've definitely seen this shift moving from a very aggressive easing cycle to a much more pronounced and prolonged easing cycle that's going to take us a while to get to where their target wants to be.

And I would also remind the audience that with the December meeting, we're also going to get a new dot plot, which we've talked about many times. It ages out pretty quickly, but it's going to give us a snapshot of at least where the Fed thinks they're headed by the end of 2025 and further out into the future.

And another critical data point, Doug, as we all know, is inflation. And you mentioned it in one of your previous comments that perhaps the Fed could potentially think about inflation a little bit differently going forward now that we've seen it come down from the really high rafters, but we have seen persistence of that core inflation around 3.3%. What implications does this have for fixed income markets as we move into next year?

From a historical standpoint, inflation is well above their targeted rate. We all know that. But core inflation's been on a pretty steady decline since it peaked at 6.6% in September of 2022 and has held kind of that 3.3% line since June with a little bit of variation, but it's down definitely from the beginning of the year, which was around 3.9%.

So, we're headed in the right direction, though it's not necessarily at the pace that the Fed would like. As long as the direction remains the same, it feels like the Fed will continue this balancing act of managing both the labor market and pricing pressure expectation.

This means that we should expect a lot more, as you said earlier, Jess, data dependency through the end of this year and into next, and the fixed income markets are going to adjust accordingly. The move higher across the yield curve is indicative of the market expectations for easing to slow, at least from what the original expectations were.

But that's dependent on the path of inflation that we've been talking about. Uncertainties around the incoming administration and the potential impact to inflation, from everything from tariffs to mass deportations, means that investors need to remain vigilant.

A continued shift higher in rates across the curve could place 2024’s calendar year returns in jeopardy with the Bloomberg US Aggregate Bond Index year-to-date return pushed below 1.5% through November 18th, and that's fueled by a loss of nearly 3% since the end of September, which is a reflection of that move higher on the curve. Spreads in the corporate market remain at compressed levels, and the securitized market has seen spreads rally throughout the year. So there is some concern that uncertainty into the future in the overall economy could lead to some spread widening, all of which just hammers home the importance of a broadly diversified allocation to fixed income as part of your overall portfolio management.

Let's shift gears now, Doug, to your latest monthly commentary, which focused on the residential housing market. And we've seen this interesting phenomenon where homeowners seem somewhat locked in or as you refer to it, the golden handcuffs, because they have these super low rates that we all got back in the heyday of low rates, but there are a lot of homeowners who are sitting on significant equity gains, and the question now is how to tap into that equity, right? How is this dynamic impacting the securitization market?

Yeah, you're right, Jess. The golden handcuffs are real. As we all know, home prices have continued to move higher, fueled by this mismatch between supply and demand. This means that homeowners that have mortgages that are, we'll call it sub 5% to 6%, aren't going to be refinancing into a higher rate in order to pull cash out of their house, and they won't be upsizing or downsizing just because it's going to be too expensive to make that move. It's just too painful for some to sell their current home, no matter how attractive the price they could get if they're sitting on a 2.5% mortgage. And then they would be forced to essentially buy a new home, whether again, upsizing or downsizing, at an elevated price. Also with a 6.5% mortgage, even if you are monetizing the equity in your home by selling, this means that we've seen growth in financial instruments that allow homeowners to tap the equity in their home without impacting their current mortgage rate.

For example, think of a homeowner with a 2.5% mortgage and $50,000 in equity. They can access that equity through a variety of financial products, and while the rate on that equity line or loan will be much higher than their current mortgage or even the current mortgage rates in the market, the blended rate makes a lot more sense than refinancing the entire mortgage at a higher rate just to pull some of that cash from their home.

We've seen a significant increase in issuance in this other category of residential mortgage-backed securities, a category that includes programs like home equity lines of credit, second mortgages or home equity loans, reverse mortgages and home equity investments. Specifically, the other category, the issuance is up nearly 180% over the same time period as last year and nearly 60% higher than in 2022.

Wow. Okay. Well, in your commentary, Doug, you explored and mentioned a few of these, just now, various home equity products. Can you walk us through a couple of those and why from a securitization perspective, they might be particularly attractive investments in the current environment?

So first, there are the tried-and-true home equity lines of credit and home equity loans, which are also known as second mortgages. These instruments follow the same approach but are slightly different in their delivery.

So, the home equity line of credit or HELOC is just what its name indicates. It's a line of credit that draws on the home equity that you have in your home, which can be paid down and then reused repeatedly during what's called the draw period, where you can access this line of credit. And again, you can pay it down or you can just keep accessing it until you enter the repayment period. The repayment period basically locks it into almost a loan at that point. And then you have, let's say 10 to 15 years to pay that off.

A home equity loan, it's the same idea, but rather than having that flexible line of credit, the homeowner receives a lump sum upfront with equal monthly payments due until the entire loan is paid off. The difference in usage is that a HELOC or home equity line of credit provides a homeowner with some flexibility, while a loan is pretty straightforward. And if there are additional funds that are needed and there's additional equity in the home, you actually have to go apply for another loan. And so that makes it a little more difficult than just that line of credit where you can kind of go in and access it over and over.

Reverse mortgages are a product that are available from both Ginnie Mae as well as from private issuers. The Ginnie Mae product is called Home Equity Conversion Mortgage, or HECM, while the private sector product is simply referred to as reverse mortgage. The idea around this product is to allow homeowners who are 62 years or older to access the equity in their homes. These are essentially designed for house-rich cash-poor borrowers. The reverse mortgage provides access to equity in the home, but it doesn't incur any additional monthly expense. For seniors living on a strict monthly budget, these financial innovations are a great way for them to tap the value of their home without altering their finances.

So that begs the question, how do lenders make money if there are no payments that are being made? Well, the loan balance negatively amortizes until a maturity event occurs. A maturity event could be the sale of the home, the homeowner passing away or the residence no longer being used as the primary residence for the borrower. An example of this would be an elderly homeowner who secures a $50,000 reverse mortgage makes no payments for the life of the loan, and then when the homeowner passes away, the home is sold and the lender is repaid the original $50,000 plus accrued interest, which is taken out of the equity in the home. So again, a way for the older generation to pull the money out of the home that they've had for however long, but it doesn't change their budget. And so, it is a very interesting way to help augment your social security or your pension payment by getting essentially this line of credit tied to your home.

Home equity investments or HEI are similar to a reverse mortgage in that there are no additional monthly costs that are incurred by the borrower. The key difference between the two is reliance on interest rates. With reverse mortgages, the interest rate calculation is based on the going market rate. So as rates have climbed, this option becomes less attractive as the associated costs climbs. HEIs are not interest-bearing and offer a potentially more attractive option to homeowners looking to tap the equity in their homes. And we'll get into that in just a second. But I would note another difference is that HEI, they do not have an age restriction. As long as there's sufficient equity in the home, any homeowner can have access to these products.

So again, how do HEI businesses earn money on their investments? We know that reverse mortgages accrue interest over time and are paid out when the homeowner passes away or sells the home. HEI takes a slightly different approach. The lender is granted the right to purchase a percentage interest in the home's future value, i.e., as home prices appreciate, the lender's percentage interest will increase at a commensurate level. A common saying in the HEI industry is that “the home pays you back, not the homeowner.” So there are agreements in place that limit the upside for the house appreciation as well as a floor if the housing market sours. HEI deals are not tied to interest rates, but rather home appreciation. So in a rising rate environment, they should remain a viable option for homeowners looking to access the equity in their home.

Very interesting, Doug. Given the current rate environment and some of these dynamics playing out in the housing market, which I would presume are likely to be persistent until we get back down to what a lot of people became accustomed to in terms of much lower rates. But how do you see the home equity securitization market evolving over the next let's call it 12 to 18 months?

Yeah, with the current environment, the growth in the home equity securitization market, it's completely understandable. The combination of an appreciating housing market combined with higher rates limits your cash-out refinancing and any kind of upward or downward mobility means that the home equity market is the best way for homeowners to gain access to the equity in their homes.

The future path of rates is going to determine whether or not the market can continue to grow at its current pace. Homeowners that have bought more recently, most likely, I will say, won't have to wait as long for a cash-out refinancing or just an overall refinancing to save on a reduced rate if longer-term rates do indeed come down. But those that bought at a mortgage rate in the 2% to 5% range are going to be looking to the home equity market to tap the value in their home. And this is going to provide loans and lines that could be securitized in the market today.

So it really depends on the direction and the velocity at which rates move. But there is a cohort, say those with sub 3% mortgages that are going to have to rely on the home equity market to pull cash from their homes for quite some time, as I don't see mortgage rates challenging those levels for a very long time. And Jess, you mentioned the rates that we've become accustomed to, but if you look historically even rates right now, mortgage rates are kind of near the historic average. So, to get back well below where we are now, I think it's going to take quite a bit of doing, and what would be happening in the economy if that were to happen is probably more concerning than the rates just going down so I can refinance my house.

But just as a way of an example, my mortgage rate, I think, is a 2 5/8% . So, though definitely, our house is much bigger than we need it to be at this point because the kids are gone, it's those golden handcuffs. It's just hard to pull the trigger and say, hey, I'm going to get out of my house. I'm getting a great price for it, but now I have to go buy what I believe is probably an overpriced house at a much higher rate.

And I think a lot of people are probably in that same boat. We're in a similar situation, so it'll be interesting to see how things evolve from here, Doug. Those are all the questions I have today. Do you have any final thoughts for our listeners?

No, I think it's a tough environment right now. And the reason I say that is, it's tough because we just don't know. And I mean, you could say that for really any time period, but I think much like September, I think December's meeting is going to be very much up in the air depending on whether they do 25 (bps) or do nothing. It's going to depend on the labor market, what we see from inflation, what we start to see from retail sales with the holiday season upon us. So, I would say stay tuned.

And then I think into 2025, we are going to have to digest what Trump 2.0 is going to mean for the economy, going to mean for the government. There's a lot of big talk, but we have to see if it'll actually be implemented. And it'll be very interesting to see though it's meant to fight inflation, I think a lot of the things that have been talked about will actually be more inflationary, which could create more problems. But no, that's about all that I had. I think staying the course and focusing on what the market's telling you is probably the most important heading into the end of the year and into next year.

Well, Doug, thank you as always. We love having you on the podcast. Before we go, I'll mention one of our upcoming events on December 10th at 2:00 PM Eastern Time. We are actually very thrilled to have Doug will be hosting our live year-end webinar with portfolio managers Austin Hawley, Krishna Monharaj and Henry Song. So check out our website for registration details — those are available now. And then Doug and I will return for another podcast in December as we close out the year. So Doug, thanks again for joining us. As always, it's a pleasure to have you.

Thanks for having me. I appreciate it. It's always fun.

For more insights and a full download of Doug's latest market commentary, visit our website at www.diamond-hill.com. Until next time, take care.