- Fixed Income Portfolio Manager
- About Us
- My Account
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Following a challenging period marked by credit spread widening in recent months, we now see attractive investment opportunities in the agency mortgage-backed security (MBS) market. In fact, for strategic investors with a longer-term time horizon, we think agency MBS has become “cheap” enough to provide a superior risk/reward profile relative to US Treasuries. Further, while we’ll admit to having a bias toward active over passive management, we believe actively managed approaches could be effective going forward in helping to navigate ongoing market volatility and dislocations in the agency MBS space.
Over the past two-plus years, the US Federal Reserve’s (Fed’s) balance sheet has more than doubled in size to US$8.9 trillion (as of 31 March 2022). Mortgages comprise US$2.7 trillion of Fed balance-sheet assets, having grown by US$1.3 trillion over the same period. Banks have been the other major buyer of agency mortgages, at times buying as many MBS as the Fed and now holding close to US$3 trillion of such securities. These brisk MBS purchases created a powerful tailwind for the asset class, pushing MBS index spreads to near historic lows.
In recent months, rising inflation has forced the Fed toward balance-sheet “normalization” sooner than expected. To wit, the Fed in May outlined its plans to end its reinvestments in MBS, with runoff caps reaching US$35 billion. While the Fed did not allude to any potential MBS sales, that remains a risk if inflation continues to broaden out. Bank purchases of MBS have also fallen amid slower deposit growth, growing loan books, a sharp increase in interest rates, and the resulting longer durations of banks’ existing MBS holdings. Finally, demand from overseas buyers (primarily Japan) has decreased significantly, as the stronger US dollar and a higher US rate structure have made it increasingly expensive for Japanese investors to hedge their exposure. In this environment, MBS have dramatically underperformed US Treasuries.
Mortgage investors have reacted to this challenging technical backdrop, with nominal spreads widening to levels not seen in 15 years (outside of those witnessed during crisis depths). This has been especially true with regard to current-coupon MBS spreads, which are derived from the MBS coupons that trade above and below a “par” price. However, most MBS investors do not buy the current coupon and instead invest in a more “index-like” allocation — an important point in that the overall MBS index has not yet widened to the same degree as the current coupon did. That’s because the lower coupons, which make up over 60% of the MBS index, were supported by technical factors and remained stubbornly expensive. But this richness has also begun to change, helping the MBS market as a whole to regain some luster on both a stand-alone basis and versus comparable asset classes (such as investment-grade corporates). Relative to corporate bonds, MBS now offer what we view as an attractive combination of potentially better carry and better downside protection in a very uncertain global market landscape.
Structurally higher market volatility and higher levels of inflation are two other key pieces of the puzzle surrounding wider mortgage spreads. Remember that mortgages are fundamentally “short” interest-rate volatility, and today’s wider spreads seem reasonable in an environment of elevated volatility. But it’s also reasonable to expect nominal spreads to tighten if volatility subsides, which could happen as the Fed’s path of rate hikes and balance-sheet normalization unfolds.
Within the overall mortgage space, we think different subsectors of the market are poised to perform very differently. For example, we believe lower-coupon mortgages (where the Fed’s holdings are concentrated) are likely to underperform their higher-coupon counterparts. This segment of the market remains relatively rich, in our view, and would be at risk of significant repricing if the Fed were to accelerate its balance-sheet normalization (Figure 1) and announce outright mortgage sales.
This could create a tough environment for passive/index-like mortgage investors. A benchmark-like portfolio would likely carry an outsized allocation to those relatively rich, lower-coupon mortgages that might be more susceptible to underperformance as the Fed begins reducing its balance sheet. By contrast, skilled active managers can actively and opportunistically rotate across mortgage sectors and the coupon “stack” in an effort to take advantage of market volatility.
The “cleanest dirty shirt” now has too many stainsContinue reading
How to interpret the Bank of Japan’s latest policy shiftContinue reading
US loses its AAA rating (again)Continue reading
More green shoots: Tracking trends in sustainable debt issuanceContinue reading
How do bond investors approach the new volatile regime?Continue reading
Credit market outlook: Partly sunny with a chance of good valueContinue reading
The “cleanest dirty shirt” now has too many stains
Fixed Income Portfolio Manager posits that US fiscal profligacy will change the game for asset allocators.
Fed not yet willing to declare victory on inflation
We think the Fed is done raising rates for this cycle, despite the likelihood that they are being overly optimistic about inflation. Read to find out why.
How to interpret the Bank of Japan’s latest policy shift
We analyse the wide-ranging investment implications of the Bank of Japan's latest policy shift.
US loses its AAA rating (again)
US Macro Strategist Michael Medeiros analyzes Fitch's recent downgrade of US credit quality and explores the bigger issues at play.
More green shoots: Tracking trends in sustainable debt issuance
While growth in the sustainable debt market has been uneven, certain pockets offer substantial opportunities. Two of our fixed income investment professionals weigh in.
How do bond investors approach the new volatile regime?
Wellington fixed income experts provide an analysis on how to navigate short-term volatility and reposition portfolios for the structural changes occurring in fixed income markets. Watch the replay here.
High yield: Opportunity to pivot in 2023?
Our high-yield bond portfolio managers have a guardedly optimistic outlook on the market and believe security selection will be key to benchmark-relative outperformance in 2023.
How to find potential in volatile European high-yield markets?
Fixed Income Portfolio Manager Konstantin Leidman discusses why European high-yield investors need to be ready for both further volatility and the emergence of new opportunities.
High-yield bonds in 2023: Fortune favours the patient
Amid ongoing dislocation in the high-yield market, Fixed Income Portfolio Manager Konstantin Leidman sees opportunities for investors to take advantage of potentially attractive valuations.
Credit market outlook: Partly sunny with a chance of good value
In his 2023 credit market outlook, Fixed Income Portfolio Manager Rob Burn highlights some potentially attractive opportunities in the wake of this year's market sell-off.