Bonds

Single-family mortgage bonds surge, with big taxable component

When the Michigan State Housing Development Authority in February priced $424.6 million of single-family mortgage revenue bonds, it was part of a broad recent surge in the sector.

The MSHDA’s new bonds — 2024 Series A tax-exempt, 2024 Series B federally taxable and 2024 Series C variable-rate federally taxable — were issued to finance the acquisition of new single-family mortgage loans and down payment assistance loans, according to the official statement.

“What we saw in 2023 was a large surge of issuers coming back into the single-family bond market — that is, HFAs who’d been out of it altogether — and selling much more taxable debt,” said Kurt van Kuller, portfolio manager at Sit Investment Associates, a Minneapolis-based privately-held asset management firm. 

“We’re seeing a lot of interest in this sector, because of the volume,” said Kurt van Kuller, portfolio manager at Sit Investment Associates.

State housing finance agencies like the MSHDA have programs offering lower interest rate mortgages and down payment assistance.

In the past, those programs were limited to first-time homebuyers or homebuyers below a certain income level. But in recent years, they have expanded to include homebuyers who don’t qualify for the traditional programs.

For decades, van Kuller said, state HFAs had another avenue for financing single-family loans: the general mortgage market. Last year, wider spreads in that market caused the shift away from it to really take off. For those trying to finance loans in the mortgage market, rates were apt to be much higher. So HFAs turned to housing bonds, both taxable and tax-exempt, instead. 

“We’re seeing a lot of interest in this sector, because of the volume,” van Kuller added. “We haven’t seen that happen in years… And it’s a function of being a more important part of the market.”

In 2023, state HFAs issued about $13.5 billion of tax-exempt ]mortgage revenue bonds to help people buy roughly 57,000 homes across the U.S., according to the National Council of State Housing Agencies.

“Right now, munis, tax-exempt, are [even] more rich,” van Kuller said. “We’re seeing a lot more buyers come into the market for tax-exempt.”

Single-family issuance overall was up 50% in 2023, according to Karen Fitzgerald, senior director and sector head for community development and social lending at Fitch Ratings. Taxable debt as a portion of that also increased, growing from $2 billion in 2022 to $7 billion in 2023, or from 17% of issuance to 35% of issuance.

“It seems to be a national trend,” Fitzgerald said. “We’re seeing it across many HFAs… Many of the states have been doing a good portion of taxable debt and have had higher issuance over the past year.”

HFAs’ annual issuance of tax-exempt private activity bonds, such as mortgage revenue bonds and multifamily housing bonds, is capped according to the state’s population and indexed to inflation.

As demand for HFA mortgages has increased, leading to more issuance, some HFAs started “bumping up against their volume cap,” said Kasia Reed, director of community development and social lending at Fitch. 

“The taxable bonds became an alternative because they’re not subject to the volume cap as private activity bonds are,” she said. 

Mortgages financed with tax-exempt bonds tend to have ceilings on borrower income and home purchase price, or requirements that loans go to first-time homebuyers. So issuing taxable bonds also enables HFAs to help a wider swath of would-be homebuyers.

But the mismatch between demand and volume caps means that most HFAs have increased production so much that more tax-exempt-eligible first-time homebuyer production is now being funded with taxable bonds, RBC Capital Markets Managing Director Cory Hoeppner said.

Fitch’s Reed also noted that tax-exempt bonds are subject to yield restriction requirements. Tax law forbids investments with a spread more than 1⅛ higher than the bond yield: “So, while not the primary reason, that’s potentially another reason for taxable bond issuance,” she said.
Issuers are not just flooding back into the bond market from the mortgage market. Prior to 2022, about a dozen HFAs had been out of the bond market altogether, relying instead on the TBA, or to be announced, market, van Kuller said. That market includes pass-through securities issued by Ginnie Mae, Fannie Mae and Freddie Mac, and its trades are forward-settling.   

“One of the fundamental differences in the TBA approach to financing mortgages is that they’re originating using a balance sheet, not bonds, and then they sell the mortgages off,” he said. “They don’t retain them. So they get a fee, but their balance sheets would not grow. In fact, they would decline over time as the bonds that they had previously weren’t replenished by new bonds.”

The TBA market has its downsides. But HFAs continued to lean on it and the general mortgage market until mortgage rates widened out in 2022.

“The decrease in efficiency of the TBA market (i.e. lower prices on TBA sales) has resulted in more HFAs selling taxable production in the bond market with taxable bonds,” RBC’s Hoeppner said.

A banker who specializes in single- and multi-family housing said that if volume issuances look low over the last decade or two, there’s a reason for that: there’s a shadow market, and it’s very hard to quantify.

Some of the surge in single-family bond issuance that they’re seeing now is flowing in from that shadow market, said the banker, who asked not to be identified. After 2008, there was a heavy reliance on the TBA market. Issuers entered the latter knowing they needed a bridge to a future higher interest rate environment — because mortgage revenue bonds are countercyclical, and tend to be more attractive when the Federal Reserve has raised interest rates. The TBA market provided that bridge.

But in the TBA market, the compensation was a one-time, upfront payment rather than a long-term revenue stream. And issuers needed revenue over time for sustainability. 

Fitzgerald said they’d noticed that HFAs’ profitability had been rising for several years, but then took a hit due to a bigger share of mortgage-backed securities on the HFAs’ balance sheets. MBS tend to be less profitable, she said.

“Part of that decline is also due to the collapse of the TBA market,” she added. “HFAs were earning these huge one-off premiums when they were selling their mortgages a few years ago…. They had these big bumps in revenue that are no longer possible in the current market. So we’ve seen some decline in profitability, and also equity has gone down as a result.”

When the HFAs jumped back into housing bonds, they issued both taxable and tax-exempt, as Michigan did in March, allowing them to purchase non-qualifying loans as well. 

“From a credit perspective, [it’s] not an issue for us… that they’re issuing taxable debt to expand [their mission],” Fitzgerald said. “We do like to see the growth in their balance sheets and their asset base, because for some HFAs, it was declining for several years, or they weren’t doing bond issuance. So the concern with the TBA market was that they had a declining asset base, and over time, they might not have ongoing cash flow from mortgage loans. Since they were selling their mortgages out to the market, that left fewer assets on their balance sheet. Which could make it more difficult to remain a viable entity.” 

The housing banker said that Michigan’s maneuver — putting variable-rate debt on the taxable side to bring the inherently higher expense of taxable bonds down a bit — is relatively common. But Fitzgerald sounded a note of caution.

“The HFAs are still doing primarily fixed-rate, which is safer from our perspective, and we haven’t really seen too much issuance of variable-rate debt like we did prior to the financial crisis,” she said.

Looking at the overall surge in mortgage revenue bonds, Sit’s van Kuller pointed to the “double whammy effect” of a spike in home prices as mortgage rates were rising.

“Down payment assistance has become the main appeal of state HFAs,” he said. “The [down payment assistance] programs are getting very lush.”

The housing sector in munis is very highly rated on average, he noted. Because the majority of HFAs have been collateralizing their programs through Fannie and Freddie, “what you have is a very solid credit,” he said.

“The investors who are most active in this sector look at the pre-payment rates,” van Kuller added. “Because we want to know how to assess the duration of the bonds. And that affects the price that we would pay, and the return that we would get on the bonds… We think that there’s a lot of value to unlock, and much more to decipher on these bonds by looking into the prepayments.”

When issuers structure their bonds, they assume a certain level of prepayments. And investors tend to look at those to gauge how long the debt will be outstanding, Fitzgerald said. If prepayments come in faster than expected, they’re going to get their money back sooner. But if the prepayment rate is slower, “there’s a concern with the yield and how that affects their bottom line,” she said.

Investors have to know how to interpret the redemptions on all these housing deals and how to do prepayment modeling, the housing banker said. But the time is ripe for new investors to jump into single-family housing bonds, because the volume is there — and there’s a promise of more volume in the near-term future, at least until the Fed lowers interest rates, the banker said.

“The market remains very strong for both tax-exempt and taxable housing bonds,” RBC’s Hoeppner said. “HFAs continue to be well-capitalized and more investors have begun to understand the strength of these programs.”

Indeed, Sit’s van Kuller said “we should enjoy it while we can.” 

“I’m not suggesting this is a permanent shift,” he said. “What’s permanent is that taxable housing issuance will remain a tool… but they may not always continue it to this extent.”

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