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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 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.