- Fixed Income Portfolio Manager, Securitized
Skip to main content
- Funds
- Insights
- Capabilities
- About Us
- My Account
The views expressed are those of the authors 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.
Credit spreads on agency mortgage-backed securities (MBS) have widened significantly, with September 2022 marking the worst month of excess return performance on record. This includes March 2020 (onset of COVID-19) and the 2008 global financial crisis. Spreads on current-coupon mortgages are now close to levels reached at the peak of the COVID pandemic. While spreads on competing assets have also widened, agency mortgages have performed worse based on historical spread volatility. This is partly due to higher interest-rate volatility. While volatility may remain elevated in the near term, we believe it is now better incorporated into market prices. Plus, MBS investors may benefit from attractive current income to help compensate for volatility risk.
After these gyrations, we view MBS valuations as being more attractive (Figure 1). Spreads may widen further if the US Federal Reserve (Fed) begins outright mortgage sales (not our base case as of this writing) or if market volatility increases, but we believe this risk is offset by competitive MBS income and potential upside from spread tightening going forward. Additionally, mortgages could serve as a “safe-haven” asset in the event of sharply deteriorating market conditions and/or a hard economic landing.
There has been heated market debate about potential outright mortgage sales by the Fed this year. We believe Fed Chair Powell’s comments at September’s FOMC meeting put that speculation to rest for the time being, specifically, his remark that [sales are] “not something we are considering right now and not something I expect to be considering in the near term.” Part of the Fed’s rationale is that the doubling of mortgage rates this year has contributed to a major slowdown in the housing market. As such, there may not be a need for additional tightening at a time when the risks of such an unprecedented move appear to outweigh the likely benefits. We believe the Fed will continue to use interest-rate hikes as its primary policy tool to tighten financial conditions.
Some have speculated that the Fed may seek to impose a floor on the size of its balance-sheet reduction. Recall that it now has a cap: If its portfolio’s prepayments rise above US$35 billion per month, it will reinvest the difference, capping its monthly balance-sheet reduction. A floor would ensure the opposite, with Fed holdings shrinking by at least US$35 billion per month. This would have the Fed selling agency MBS equal to the shortfall, in prepayments below that threshold. We do not think this is likely.
We anticipate natural paydowns in the current rate environment to be in the range of US$20-25 billion per month. To reach the floor, the Fed would need to sell close to US$10-15 billion of mortgages per month, or around US$150 billion per year. This is not a trivial amount for the market to absorb, but it’s not large enough to meaningfully change the trajectory of the Fed’s US$2.7-trillion mortgage portfolio. Based on this asymmetry, it does not seem worth introducing a new tool with limited benefit to a market already worried about liquidity.
With a reduction in these risks, one might expect agency MBS to have performed well, but they haven’t. There are a few reasons why:
To summarize, MBS valuations have cheapened meaningfully amid rising rates. Fundamentals are better now, with almost the entire MBS index substantially out of the money to refinance. But technicals are now the biggest driver of performance. While the market may remain volatile for some time, we believe this presents a good entry point for investors with a longer-term horizon. We also note that the current environment of heightened volatility should enhance the benefits of active management, helping portfolios to weather uncertainties and take advantage of large differences in relative attractiveness across the coupon stack.
Experts
Are US election probabilities now a critical driver of bond yields?
Continue readingCapitalizing on rate shifts: Parsing opportunities in the second half
Continue readingReframing fixed income portfolios: why bond maths makes the difference
Continue readingJune FOMC meeting: May disinflation is welcome, but is not enough for a rate cut
Continue readingURL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Are US election probabilities now a critical driver of bond yields?
Our expert argues that the US election remains a critical catalyst for the bond market given the contrast between both parties as it relates to supply side policies such as trade and immigration, and to policy differences around taxation and regulation.
Time for credit selection to shine
Fixed income investors continue to seek answers to an era of volatile rates. Large, static exposures to credit markets no longer cut it. Instead, a nimble and dynamic approach is more likely to create resilient and consistent total return outcomes.
Bond Market Outlook
Our fixed income experts assess how to capitalize on market volatility with a flexible and dynamic approach that leverages diverse high-yielding opportunities and manages risks carefully.
Capitalizing on rate shifts: Parsing opportunities in the second half
Fixed Income Portfolio Manager Campe Goodman and Fixed Income Strategist Amar Reganti discuss how to capitalize on potential rate shifts in the second half of the year
Reframing fixed income portfolios: why bond maths makes the difference
It is easy to understand why fixed income investors tend to focus on yields. But investors who focus too much on yield may run the risk of overpaying for income and underestimating the impact of price volatility.
June FOMC meeting: May disinflation is welcome, but is not enough for a rate cut
Fixed Income Analyst Caroline Casavant discusses what June's FOMC meeting tells us about the US Federal Reserve’s latest thinking on interest-rate cuts.
Has the European credit cycle been extended?
2024 has kept fixed income investors busy. Yet, despite lingering inflation and rate volatility, European credit markets have remained strong. Are we looking at an extended credit cycle? And if so, what does this mean for investors?
Governments have been slow to reduce their fiscal deficits — it could cost them
Our expert explores the investment implications of continued excessive deficit spending by G7 countries.
Looking beyond yield: Rethinking the approach of fixed income investing
Investors face a new regime, challenging traditional assumptions about returns and volatility. With central bank interventions impacting credit markets, it’s time to rethink income allocations. Rather than fixating solely on yield, consider a dynamic approach, presented by Connor Fitzgerald.
Structuring core fixed income: A constructive view on market and macro conditions
Head of Multi-Asset Strategy Adam Berger and Fixed Income Portfolio Manager Connor Fitzgerald discuss the interest-rate environment and the fundamental picture in investment-grade credit and high yield.
New era demands a nimble approach to credit
Our expert explains why deep research and an active approach are effective ways for fixed income investors to uncover credit opportunities in today's market.
URL References
Related Insights