Guide to Mortgage Investing

GUIDE TO MORTGAGE INVESTING

Mortgage-backed securities and mortgage-related fi xed income instruments is a large, multi- trillion dollar bond market providing diverse sources of income in fi xed and fl oating rate structures. In this guide, we provide an overview of the agency Mortgage-Backed Securities (MBS), Credit Risk Transfer (CRT) securities, non-agency Residential Mortgage-Backed Securities (RMBS), and Commercial Mortgage Backed Securities (CMBS) markets. This guide will also discuss the risk and return characteristics of these bonds to provide a perspective on how they could fi t in your clients’ portfolios.

For investment professional use only. Not for inspection by, distribution or quotation to, the general public. AGENCY MORTGAGE-BACKED SECURITIES

Agency MBS (Mortgage-Backed Securities) are bonds backed by a pool of mortgages, issued by the U.S. Government- Sponsored Enterprises (GSE) Fannie Mae and Freddie Mac (and also Ginnie Mae). The mortgages that back agency MBS have to conform to the lending standards set out by those agencies, which today, for Fannie Mae and Freddie Mac MBS, are very strict. The principal and interest of Agency MBS securities are guaranteed by the agencies that issue them. All of the GSEs are backed by the US Treasury department.

THE AGENCY MBS CREATION PROCESS

Fannie Mae/Freddie Mac purchases …and issue MBS. They ‘pass-through’ Banks originate loans that conform to their the cashﬂow from those mortgage individual mortgage loans standards and pools them together… loans to MBS investors

MORTGAGE POOL MBS

For illustrative purposes only. Source: AllianceBernstein (AB)

RISK AND RETURN CHARACTERISTICS OF AGENCY MBS Agency MBS are guaranteed by the GSEs that issue them, and because of that, they are considered to have very little risk of default. Consequently, their yield is generally quite low, usually only offering a small pick-up over US treasuries.

Their main risk factors are interest rate risk and pre-payment risk. The interest rate risk stems from the fact that because they are considered to have little risk of default, historically, they have a very high correlation with US treasuries (~0.8). Pre-payment risk is the risk that the underlying mortgage borrowers re-pay their mortgages earlier than expected (e.g. selling their house or reﬁ nancing their mortgage), which reduces the amount of future interest payments from the mortgage pool. This can negatively impact the price of the affected MBS, especially if the bond is trading at a premium to par.

On the other hand, the agency MBS market is one of the most liquid ﬁ xed income markets in the world, with trading volumes typically in the trillions of dollars per year, involving many different types of investors.

SUMMARY CHARACTERISTICS

Current range of yield: 1.75 – 2.5% (mostly ﬁ xed) Main risk factors: Interest rate risk and Pre-payment risk Liquidity: High Ourperforms when... Interest rates are stable and mortgage prepayments are low Underperforms when... Interest rates are volatile and/or mortgage prepayments are accelerating

2 For investment professional use only. Not for inspection by, distribution or quotation to, the general public. CREDIT RISK TRANSFER SECURITIES

Credit Risk Transfer securities (CRT) are mortgage-related bonds issued by US housing agencies Fannie Mae and Freddie Mac. CRTs issued by Fannie Mae are called CAS (Connecticut Avenue Securities), and the ones issued by Freddie Mac are called STACR (Structured Agency Credit Risk). These bonds generally offer higher yields than agency MBS, because they are not guaranteed by the housing agencies, but instead transfer a portion of the credit risk (defaults) of these mortgage pools from Fannie Mae and Freddie Mac to the CRT investor. Currently, Fannie and Freddie’s mortgage pools feature very solid, prime credit metrics due to the signiﬁ cant tightening in mortgage lending standards in the US after 2008, which we think will likely underpin very low default rates for the current outstanding CRTs. It is important to understand that these prime mortgages are much better quality than subprime mortgages pre-2008. HOW DID CRTs COME ABOUT

During the Financial Crisis of 2008, the US government took over Fannie Mae and Freddie Mac due to the losses they had suffered during the unprecedented downturn in the US housing market. Thereafter, the government looked for ways to diversify some of this risk (AB was consulted by the US Congress on how to do this), and ultimately, it was decided that Fannie Mae and Freddie Mac would ‘share’ the risk of their mortgage portfolio with investors, paying them a ﬂ oating rate coupon to partially take on the guarantee on their mortgage pool. In many ways, this is like Fannie and Freddie buying reinsurance on their mortgage portfolio.

In return for partially taking on the guarantee for the mortgages underpinning Fannie Mae and Freddie Mac’s MBS, investors receive a fl oating rate coupon benchmarked to USD 1 month Libor + a spread. This feature about CRTs is particularly interesting in today’s environment, given that the Federal Reserve is expected to continue to hike interest rates. STRUCTURE OF CRTs CRTs are structured in tranches, with losses from defaults fl owing from the bottom-up, i.e. any losses will be fi rst absorbed by the bottom tranches before the upper tranches are affected. Investors can invest in classes M1, M2, M3, B1, and B2, depending on their income requirements and risk tolerance. At every tranche, potential losses from defaults in the underlying mortgage pool are shared with the housing agencies at specifi c ratios. For example, in the below illustration where we look at a recently issued Fannie Mae CAS, we can see that Fannie Mae retains 80% of the potential losses in class B-2 tranche (in green) while investors retain the remaining 20% (in blue). Meanwhile classes M-1, M-2, B-1 retain 95% of the potential losses, and Fannie Mae retains only 5%.

Because the bottom tranches absorb losses ﬁ rst, they also provide the highest coupons among the various tranches. Conversely, because the upper tranches are the last to take losses (that is, they are protected by the bottom tranches), they would offer lower coupons relative to the bottom tranches.

CRTs are issued effectively at 10-year maturities and they are not callable during this period. This is an important distinction, because unlike bank loans, which are callable on the ﬁ rst day they are issued, the fact that CRTs are not callable for 10 years will ensure investors will receive that ﬂ oating rate coupon during the life of the bond (unless the bond defaults). THE CREDIT RISK TRANSFER MODEL

Traditional Government Government Risk CRT: Security Structure Backed Model Sharing Model Floating Coupon Government Class A-H CRT Investors Sponsored Entities 95.9% GSE Retention (GSE) Share Credit Risks With GSEs Class M-1 Credit Risk Baa3 GSEs Guarantee Mortgage Pool Credit Risk to MBS Class M-2 Investors Ba3 Prepayment Order of Losses of Order

Risk Class B-1 5% GSE Retention Mortgage Class Pass-Through B-2 80% GSE Retention Investors For illustrative purposes only. As of 31 March 2017 Source: Freddie Mac, Fannie Mae, and AllianceBernstein (AB)

For investment professional use only. Not for inspection by, distribution or quotation to, the general public. 3 CREDIT RISK TRANSFER SECURITIES

RISK/RETURN CHARACTERISTICS OF CRTs CRTs provide yields ranging from Libor + 100bps to as high as Libor + 800bps of ﬂ oating rate coupons (paid out monthly). Their performance is generally correlated with the credit markets, such as US high yield, but it’s historical volatility has been meaningfully lower than high yield bonds. If the Federal Reserve continues to hike interest rates in the US, the coupons on CRTs will also adjust higher in line with short-term interest rates.

The risk to investors when they invest in CRTs are potential defaults in Fannie Mae and Freddie Mac’s mortgage pools. However, we believe losses from the mortgage pools should only be about 0.2% (compare that to the high yield market’s current default rate of ~3%) over the next few years driven by several factors including:

+ Each CRT references a highly diversiﬁ ed pool of about 80,000 – 110,000 mortgages. + The US labor and housing markets remain robust. + Underwriting standards have tightened up signiﬁ cantly post 2008, examples include FICO scores (US borrower credit risk scores, which range from 300 to 850) are strong, and roughly 98% of borrowers have debt-to-income ratio below 50% (see charts below).

LENDING STANDARDS HAVE TIGHTENED SIGNIFICANTLY DEFAULT RATE REMAINS LOW

770 20% 0.60 Average Personal Credit Score1 760 18% 0.50 The vast majority of 16% 750 borrowers have FICO 14% 740 scores above 700† 0.40 12% 730 10% 0.30 720 CAS 2014-C02 Group 1 Model 8% Delinquencies Expectations* 710 0.20 6% 700 4% Proportion of 0.10

Over 60 Days Delinquent (Percent) - 690 Higher Risk Mortgages2 2% CAS 2014 C02 Group 1 Actual Delinquencies 680 0% 0.00 99 01 03 05 07 09 11 13 15 1 10 19 28 37 46 55 64 73 82 91 100 109 118 Weighted-Average Loan Age (Days Past 60 Days) Historical analysis does not guarantee future results. As of 31 March 2017 * Based on AB’s proprietary model forecast expectations of delinquencies; CAS 2014-C02 Group 1 is a pool of mortgages that consists of mortgage loans with loan-to-value ratios less than or equal to 80%. † FICO score is a type of credit score that helps lenders assess borrower’s credit risk. Typically, scores above 650 indicated a very good credit history. FICO scores and Debt to Income ratios is for borrowers backed by Freddie Mac. Source: Freddie Mac and Alliance Bernstein (AB). 1 Personal credit score as measured by FICO score in the US. 2 Higher risk mortgages deﬁ ned as mortgages with debt to income ratio greater than 50%.

SUMMARY CHARACTERISTICS

Current range of yield: 2 – 9% (ﬂ oating rate) Main risk factors: Defaults in Fannie Mae and Freddie Mac’s mortgage pool Liquidity: Low to medium (comparable to high yield corporates) Ourperforms when... Economy is strong and housing market is solid Underperforms when... Economy is weak and/or housing market is stressed

4 For investment professional use only. Not for inspection by, distribution or quotation to, the general public. NON-AGENCY RMBS

Non-agency residential mortgage–backed securities (RMBS) are private-label RMBS issued by banks, and not by the housing agencies Fannie Mae or Freddie Mac. Their underlying collateral generally consists of mortgages which do not conform to the requirements for inclusion in agency mortgage-backed securities due to their size, documentation, loan-to-value ratios, or other reasons. New issuance of these bonds has essentially dried up after 2008 due to banking regulations and the market continues to shrink every month.

SHRINKING SUPPLY OF THE NON-AGENCY RMBS SIZE OF THE NON-AGENCY MARKET

2,000 1,800 1,600 Supply of non-agency RMBs has dried up due to bank regulations 1,400 Subprime 1,200 Prime Hybrid 1,000 Prime Fixed 800 Option ARM USD Billions 600 Alt A Hybrid 400 Alt A Fixed 200 0 2009 2010 2011 2012 2013 2014 2015 2016 2017

Past performance does not guarantee future results. Historical information provided for illustrative purposes only. As of 31 March 2017. Source: Case-Shiller, Corelogic, Federal Reserve Board, Freddie Mac, J.P. Morgan, National Association of Realtors.

TYPES OF NON-AGENCY MORTGAGES

Jumbo Prime Mortgages are high-quality mortgages that meet underwriting guidelines similar to those set for agency mortgages by Fannie Mae and Freddie Mac. These mortgages tend to fall into the non-agency market because loan balances are greater than those allowed by Fannie Mae and Freddie Mac for conforming loans.

Alternative-A (Alt-A) Mortgages fall between Prime and Subprime. Credit scores of these borrowers are typically average or above average, but looser loan documentation requirements or larger loan size disqualify these from conforming to Fannie Mae or Freddie Mac underwriting guidelines.

Option Adjustable Rate Mortgages (Option ARMs) are a type of Alt-A loan that is unique due to its ﬂ exible repayment terms. Option ARM mortgages allow for several payment options including making interest only or less than interest due payments. As a result, the outstanding loan balance can increase over time (negative amortization). These loans were designed to start with an attractively low rate of interest (the “teaser rate”) to attract borrowers.

Subprime is a class of mortgage extended to borrowers with low credit ratings. In general, these borrowers have damaged credit or limited credit history, and provide minimal income and asset veriﬁ cation. Due to the default risk associated with these borrowers, lenders tend to charge a higher interest rate on subprime loans.

For investment professional use only. Not for inspection by, distribution or quotation to, the general public. 5 NON-AGENCY RMBS

RISK AND RETURN CHARACTERISTICS OF NON-AGENCY RMBS The risk of non-agency RMBS is the credit risk of the mortgage pool underlying these securities, and as described above, credit quality is highest for Jumbo Prime, followed by Alt-A and Option ARMs, and the lowest quality being subprime.

The risk profi le of non-agency RMBS have changed dramatically after the Global Financial Crisis in 2008. In the immediate aftermath of the crisis, many of these securities experienced considerable defaults within the securitization, and so credit ratings and prices have since adjusted to refl ect these defaults (typically CCC ratings, with prices ranging generally between $70 - $95). Consequently, we don’t expect investors in these bonds will receive the securities’ full face value, but will likely get back between $85 to $95 at maturity. Because the prices of these bonds currently already refl ect this, these bonds are not really CCC risk, in our opinion, as even if investors do not receive par value at maturity, they would still likely earn a mid-single digit level of yield to maturity.

NON-AGENCY RMBS HAVE RECOVERED WITH HOME PRICES

210 120 Peak Home Price (Apr 2006)

190 100

Non-Agency RMBS Price US Dollars

170 80

US Home Price Index 150 60

130 40

Past performance does not guarantee future results. Historical information provided for illustrative purposes only. Home prices as of 31 January 2017 and non-agency RMBS prices as of 31 March 2017 Source: Case-Shiller, Corelogic, Federal Reserve Board, Freddie Mac, J.P. Morgan, National Association of Realtors

SUMMARY CHARACTERISTICS

Current range of yield: 3.5 - 5% (ﬁ xed, except for Option ARMs) Main risk factors: Defaults in underlying mortgage pool Liquidity: Easier to sell, harder to purchase Ourperforms when... Economy is strong and housing market is solid Underperforms when... Economy is weak and/or housing market is stressed

6 For investment professional use only. Not for inspection by, distribution or quotation to, the general public. COMMERCIAL MORTGAGE-BACKED SECURITIES

Commercial Mortgage-Backed Securities (CMBS) as their name implies, are bonds backed by pools of commercial mortgages. Commercial mortgage pools typically are combinations of loans that ﬁ nance a variety of properties. These include ofﬁ ce buildings, hotels, ‘multifamily’ housing such as apartments or condominiums, retail properties including shopping malls, and industrial buildings such as warehouses and factories. These mortgages are securitized and used as collateral for CMBS bonds created through a special-purpose vehicle.

Most loans have maturities of 10 years, but they do not completely amortize over that period, and so the borrower will make a large ‘balloon’ payment of principal back at maturity (usually through a reﬁ nancing of the loan or sale of the property). These bonds are issued in a tranched structure, with different tranches having different degrees of loss protection (protection provided by lower tranches that absorb losses ﬁ rst), yields and duration. A typical CMBS structure would look like the below:

TYPICAL CMBS STRUCTURE

CRT: Security Structure

Super Senior AAA PAYMENTS AND RECOVERIES

Mezzanine AAA Tranches have a sequential payment structure: the more senior bonds are paid ﬁrst and the subordinated bonds absorb the ﬁrst losses. Consequently, the Junior AAA senior bonds tend to offer lower yields while the AA subordinated tranches offer higher yield. LOSSES A BBB BB B Unrated For illustrative purposes only. Source: Alliance Bernstein (AB)

RISK AND RETURN CHARACTERISTICS OF NON-AGENCY RMBS The main risk factor to consider when investing in CMBS is the extent of defaults in the underlying mortgage pool (and how far up they ﬂ ow in the securitization). The sector recently has come under pressure because of negative headlines about some retailers struggling in regions and locations that haven’t gotten as much of a boost from the economic recovery. When we invest in CMBS that include the underlying loans in these locations, we think it is critical to stress-test the assumptions behind to understand the extent of the ultimate losses, or to avoid buying securities with these loans in their mortgage pools.

We do believe there is a secular trend underway of consumers increasingly turning towards online retail, but we think the pessimism may have become excessive and that the market expects the losses to happen too quickly. However, it is precisely because of this excessive pessimism that has created very attractive valuations in the CMBS space (e.g. some BBB-rated tranches are now trading at US high yield corporate levels). We think the opportunity lies in mortgages originated between 2010 – 2014 when underwriting standards were still quite conservative.

SUMMARY CHARACTERISTICS

Current range of yield: 4 - 8% (ﬁ xed) Main risk factors: Defaults in underlying mortgage pool Liquidity: Lower for subordinated tranches, high for AAA-rated tranches Ourperforms when... Economy is strong and commercial property market is solid Underperforms when... Economy is weak and/or commercial property market is stressed

For investment professional use only. Not for inspection by, distribution or quotation to, the general public. 7 GENERAL SUMMARY

Outperforms Underperforms Sector Yield Risk Liquidity when... when...

Interest Rate Risk Interest rates are Interest rates are Agency MBS 1.75-2.5 High Prepayment Risk stable volatile

Strong economy/ Defaults in Fannie Low to Medium Weak economy/ 2.0-9.0 labor markets and CRTs Mae and Freddie Mac (similar to high labor markets, and (ﬂ oating) solid housing mortgage pools yield corps) poor housing market market

Strong economy/ Weak economy/ Non-Agency Defaults in mortgage Easy to sell, hard labor markets and 3.5-5.0 labor markets, and RMBS pools to buy solid housing poor housing market market

Low for Strong economy Weak economy and CMBS Defaults in mortgage sub-tranches, and solid 4.0-8.0 declining commercial (mezzanine) pools high for AAA commercial property market Super Seniors property market

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