The Case for Mortgage Credit

There are two main risks in residential mortgage investment - interest rate risk and default risk. Mortgage credit investments isolate the default risk, and we think they are one of the best defensive allocations in fixed income today.

The US does not have enough housing, especially in places where families want to live. Housing construction has not kept pace with household formation due to post GFC underbuilding. Land constraints, permitting, construction costs, higher financing rates - all limit how fast new supply can come online. Estimates vary, but the housing shortage is generally placed at 2 to 5 million homes, with a recent Realtor.com estimate of about 4 million. That is only around 1-4% of the total US housing stock, but the Fed has noted that even a relatively small shortage can have a significant impact because housing markets need vacant and available units to function properly.

That matters because homes are the collateral for mortgage credit.  Housing prices also have a natural relationship with inflation. Replacement costs rise when labor, materials and land become more expensive, and rents also tend to adjust over time. A house is not a perfect inflation hedge, but the collateral backing mortgage credit has characteristics that make it useful in a high-grade portfolio, as shown on the chart below.

Let’s contrast this with corporate credit.  Corporate bond supply is growing quickly, with US issuance reaching approximately $1.9 trillion through August 2026, up nearly 30% from a year earlier according to SIFMA. Spreads are already tight in many parts of the market. Moreover, higher interest rates create pressure for leveraged borrowers. We are watchful of the data-center buildout (see When AI Needs Less), where enormous amounts of debt capital are being committed against aggressive assumptions about future demand. Even if the economy remains healthy, there isn’t much excess spread left in corporate bonds to offset mistakes.

Consumer credit has a different set of problems. Stress remains visible in subprime borrowers, particularly in auto lending, while credit card and auto delinquencies remain elevated relative to pre-pandemic norms. While the consumer is not collapsing, and recent deterioration has not been broad-based across every category, the weakness at the lower end of the FICO spectrum makes us reluctant to treat consumer credit as an obvious defensive alternative.

Housing looks different.

In a strong economy, homeowners continue to benefit from employment and income growth, while limited housing supply supports collateral values. In a stagflationary environment, higher replacement costs and constrained construction should provide some protection against inflation. And in a recession, housing would weaken, but the shortage of well-located shelter stock creates a very different starting point from prior cycles characterized by substantial overbuilding.

Starting points are key here. The housing crisis of 2008 occurred because of excess supply, weak underwriting and excessive leverage. Today, the US faces a potential rates driven downturn with the opposite problem: too little housing in places where demand is strongest.

None of this makes housing credit immune to recessions and higher unemployment. Deal structure and borrower quality still matter. But when we compare the major fixed-income sectors, housing rests on something we find increasingly scarce elsewhere: constrained supply and hard collateral.

For a defensive allocation, we like that combination.