As fixed-income markets have started to recover following the massive selloff and liquidity crunch in March, credit risk-transfer securities (CRTs)―agency mortgage securities not guaranteed by Fannie Mae and Freddie Mac―have been slower to do so. Investors are wondering: Where do CRTs go from here?

To answer this question, we believe it’s important to look at the reasons for CRTs’ larger underperformance in March. Initially, the drawdown was driven by concerns about housing-market fundamentals, as investors feared that unemployment caused by the economic lockdown to slow the spread of COVID-19 would lead to a spike in mortgage delinquencies and defaults.

The selloff was exacerbated by the fact that many investors—such as mortgage REITs and hedge funds—who were attracted by CRTs’ strong underlying quality had levered their exposure. As bond prices fell and the repo markets came under pressure, these investors became subject to margin calls, forcing them to sell. This created a perfect storm for CRTs.

While CRT prices have started to recover, spreads are still multiple times their pre-crisis levels, more than compensating investors for increased risk associated with COVID-19. The current environment is certain to impact many of the mortgage borrowers and to increase the credit risk in the underlying mortgage pools. However, there are many reasons why we continue to favour this sector. In fact, CRTs continue to offer solid fundamentals at a time when corporate credit metrics look stretched.

Before diving deeper into the fundamental picture, it is helpful to understand how CRTs are structured.

WHAT ARE CRTs

CRTs are typically issued by government-sponsored housing agencies Fannie Mae and Freddie Mac. Like typical agency bonds, CRTs pool thousands of different mortgages into a single security, and investors receive regular payments based on the performance of the underlying loans. But there’s a key difference: CRTs carry no government guarantee. Investors could absorb losses if a large number of the loans default.

CRTs are issued in tranches. Lower-tiered bonds absorb losses first, followed by higher-rated tranches if losses are more severe (with the most senior tranches receiving prepayments first). GSEs retain a share of the risk for each security they issue—that’s why the securities are referred to as risk-sharing bonds.

The underlying mortgages are the same ones included in the agency mortgage pass-through pools, with strong-credit borrowers that conform to the GSE’s standards.