Cash-on-cash returns, improving fundamentals, and a narrowing of risk premiums are lifting prices of nonagency mortgage-backed securities. The improvement is contributing to significantly to total returns for the market and its individual subsectors.

Within the nonagency MBS sector, prime senior securities grew to $90.38 at the end of August from $86.65 at the end of May and continue to climb. Subprime senior securities stood at $55.71 at the end of August from $53.07 at the end of May, with prices still rising (see chart below, provided by Amherst Securities).

This sharp runup in prices reflects favorable changes in both technicals and fundamentals, Laurie Goodman and her team of analysts at Amherst say.

“We believe that returns will remain strong, although going forward we certainly expect a less dramatic run-up than experienced over the past few months,” they write in a research note. “The macroeconomic environment is the greatest risk to this sector, but even if the outlook for the global economy deteriorates, we believe non-agency MBS will continue to outperform alternatives.”

The nonagency mortgage market has shrunk nearly in half from $1.88 trillion at the end of 2008 to $986 billion today. The trend, Goodman says, reflects scheduled principal repayments, voluntary prepayments and liquidations on legacy securities, offset by only miniscule new origination. The fixed income market has grown 21.4% in that period, while the non-agency sector compressed 47.5%.

At the current rate, the nonagency market will total $750 billion by June 2014 after peaking at $2.2 trillion in 2007, Amherst predicts.

Goodman says strong home prices are making investors more optimistic about housing and allowing them to discount some of the very negative scenarios that had been in use.

The scarcity of agency mortgage-backed securities intensified by the Federal Reserve third round of quantitative easing is adding momentum to the nonagency subprime MBS sector rally.

Goodman’s words echo those from analysts at Bank of America (BAC), who attribute the non-agency rally to factors such as the sale of the Maiden Lane nonagency MBS portfolio in the spring, the announcement of more favorable capital treatment for broker/dealers for non-investment grade nonagency MBS, and strengthening home prices.

And loan modification success rates are improving, which means that that a lower percentage of modified loans will redefault. On top of that, transition rates — the rate at which borrowers who have never been two payments behind are falling two payments behind for the first time — continue to drop.

“As a result, the range of outcomes for non-agency securities has been narrowed,” Amherst contends. “With transition rates coming down steadily, confidence that home prices will not fall a lot further, and improvements in modification success — the risk premium on nonagency mortgages is expected to diminish.”