JLS - JLS: Take Advantage Of The 2024 Housing Reversal With This 10% Yielder

2023-12-26 12:08:01 ET

Summary

• U.S. home sales declined in 2022 and continued to cool down in the first half of 2023 due to high mortgage rates and low inventory.
• Housing prices have risen over the past two years and may continue to increase in 2024, but lower mortgage rates could spur more sales.
• Nuveen Mortgage and Income Fund, which invests in mortgage-backed securities, offers a high current income and may benefit from reduced inflation and an improving MBS landscape.

While the battle over inflation rages on into the end of 2023 and the Federal Reserve considers its next move with respect to interest rates, the housing market remains constrained by high mortgage rates and low inventory. According to Statista , U.S. home sales declined in 2022 after surging in 2021 to the highest level since 2006. Through the first half of 2023, the market continued to cool down, as shown in this chart of annual home sales through May 2023.

Low inventories of homes for sale along with higher mortgage rates have caused housing prices to rise over the past two years and may continue to increase in 2024. Mortgage rates have started to come down in the past couple of months, but are still high relative to the past few years. High mortgage rates and rising prices have dissuaded homebuyers, but that could change in 2024. According to this 2024 housing market forecast from Bankrate, housing sales are likely to increase a bit in 2024 as more buyers enter the market.

"Retreating mortgage rates will bring more buyers and sellers to the market and get Americans moving again," says NAR chief economist Lawrence Yun. At a NAR conference in November, Yun predicted that sales will rise by as much as 15 percent next year.

"Housing sales are expected to increase a bit from this year," says Chen Zhao, who leads the economics team at Redfin. "However," she qualifies, "we are not expecting sales to increase dramatically, as rates are likely to remain above 6 percent."

"Lower mortgage rates would help spur home sales activity, which are expected to increase in 2024 compared to 2023," says Selma Hepp, chief economist at CoreLogic. "Declines in mortgage rates will drive more sellers to trade their existing home and help add much-needed inventory to the market, leading to more transactions."

For investors seeking income from securities that invest in the real estate market, now may be a good time to load up on funds that hold MBS (mortgage-backed securities) and other securitized credit instruments that may benefit from reduced inflation and an improving economy as we move into the new year. One such fund is a closed-end fund, or CEF, offered by fund sponsor Nuveen that invests at least 65% of its assets in MBS, and up to 35% in non-mortgage asset-backed securities: the Nuveen Mortgage and Income Fund (JLS).

From the fund website , the fund description explains that the fund's objective is to provide high current income via opportunistic investments in securitized credit:

The Fund invests at least 65% of its managed assets in mortgage-backed securities ((MBS)), including residential MBS and commercial MBS, and up to 35% in non-mortgage related asset-backed securities ((ABS)) including but not limited to any asset that generates reliable cash flows including collateralized loan obligations as well as pools of consumer auto loans, credit card receivables, aircraft leases and maintenance agreements, timeshare agreements, and solar photovoltaics. A maximum of 5% can be invested in catastrophe bonds, which are backed by a secured collateral account and considered by the Fund to be ABS.

The JLS fund offers investors a monthly distribution that has been raised twice during 2023 and currently yields about 10% annually. In addition, JLS announced a special dividend of $0.0566 to be paid on December 29. The price of the fund has risen substantially since mid-November, when the Fed first hinted that rates may be finished rising for now.

JLS Fund Overview

From the fund fact sheet, as of 9/30/23, the fund holdings included about $140 million in total managed assets, and the fund employs leverage of about 28%. The inception date of the fund was November 2009 and annual returns since inception amounted to 5.7% at NAV (as of Q323) and 4.57% at market price. The current NAV as of 12/22/23 is $18.79 and the last closing price as of that date was $17.05 resulting in a discount of about -9%. The discount has been closing over the past six weeks, as can be seen in this chart from CEFconnect, which shows the average 52-week discount at nearly -14%.

As of November 30, 2023, the fund holdings included 163 securities with effective maturity of 17.78 years and an average leverage-adjusted effective maturity of just 1.8 years. The maturity breakdown is further illustrated on the website:

The top 10 holdings indicate the concentration of MBS that make up the majority of fund holdings and include both Freddie Mac and Fannie Mae backed securities in the form of STACR REMIC structured offerings and Connecticut Avenue Securities , respectively.

Digging a little deeper into each of these types of securities, we can see that the Freddie Mac vehicles pay interest and principal on a monthly basis and provide other benefits to noteholders, as explained on the Freddie Mac website :

STACR REMIC structures offerings as notes issued by a trust that is treated as a Real Estate Mortgage Investment Conduit ((REMIC)). The trust pays interest (uncapped LIBOR floater) and principal (less credit and/or modification losses) to noteholders on a monthly basis. Credit and prepayment performance of the reference obligations determines performance of STACR REMIC securities.

Benefits of STACR REMIC:

• Reduces counterparty risk exposure to Freddie Mac
• Avoids any disruption of To-Be-Announced ((TBA)) market
• Eliminates Commodity Pool Operator ((CPO)) requirements
• Qualifies as a REIT-eligible investment
• Does not subject international investors to U.S. withholding tax and offered as Regulation S

Likewise, CAS offers a credit risk transfer REMIC option for Fannie Mae MBS holdings, as explained in this fact sheet .

Reading the fund commentary from Q323, the contributors to fund performance included the floating rate credit aspect of those CRTs (credit risk transfers) as interest rates rose. Detractors from fund performance included the CMBS sector holdings.

Contributors

In general, floating-rate credit such as credit-risk transfers (CRTs) and CLOs did well in the face of a rising yield curve during the period. (CRTs use subordination structures to reduce public risk on mortgage-related securities, offering partial guarantees for loans based on the credit quality of the loan pools.) In MBS, performance was particularly strong in deeply subordinated tranches of CRT paper.

In ABS, returns were led by CLOs, where the biggest returns were in BB and B rated tranches. ABS total returns for the third quarter were modest overall and largely a result of a spread tightening bias for most names during the period. This was offset by higher yields, which detracted from returns. The 10-year Treasury yield entered the period at 3.81% and exited close to a multi-decade high of 4.59%. The Fund also benefited from other liquidity events in ABS space in the form of calls, refinancing activity and paydowns.

The credit quality of fund holdings includes about one-third that is rated investment grade (BBB and higher), with the remaining two-thirds below investment grade, as shown in the sector and credit quality allocation table from the fund's website. Notably, most of the CMBS holdings are rated as investment grade, while the majority of RMBS is below investment grade. The ABS holdings are about evenly split.

MBS Interest Rate Impacts

In this recent article describing AGNC Investment Corp (AGNC), another investment opportunity that should benefit from investments in MBS that are likely to rise as interest rates fall, the author points out that MBS values have dropped over the past 18 months as interest rates have risen. Now that it appears that interest rates are no longer rising, MBS values are heading back up again. This chart of 30-year MBS prices from Mortgage News Daily illustrates how that inflection point occurred around early November, coinciding with the rise in the price of JLS.

While the rate of inflation continues to fall and assuming that the Fed follows through with the plan to reduce the base interest rate in 2024, the MBS values should continue their upward trajectory. In a recent blog post from Eaton Vance, the forecast for the MBS market in 2024 is positive due to limited supply among other factors:

KEY POINTS 1. Agency mortgage-backed securities spreads sit over 100 basis points (bps) wider than their 2021 lows. While spreads have been at historically wide levels for the last two years, an improving technical landscape in 2024 will likely pave the way for tighter spreads. 2. The average mortgage rate of existing homeowners with a mortgage sits at just 3.74% as of December 1, making it uneconomical for existing mortgage holders to move or refinance, dampening supply in the agency MBS market in 2024. 3. We expect the focus to shift in the agency MBS market from extension protection to call protection in 2024. With the specter of recession and credit defaults on the horizon, money manager demand for agency MBS is set to pick up in 2024.

In that scenario, I believe that JLS will continue to close the discount to NAV and will continue to support the current distribution and may even raise it again next year. There has been a small amount of ROC in the 2023 distributions as shown on CEFconnect, but not destructive ROC because the NAV continues to increase, and the fund is even paying out a special dividend this year.

While there is a risk that the economy will remain strong and inflation will continue to linger longer than currently anticipated, the current trends and leading indicators all point to lower interest rates by the second half of 2024. Given this market environment and the optimism surrounding the MBS landscape, I believe that Nuveen Mortgage and Income Fund represents a buying opportunity for income investors who are interested in protecting their capital investment.

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