Bonds
David Betanzos
Shriya Gehani
Margaret Steinbach
Mortgage-backed securities (MBS) have cheapened considerably as interest rate volatility has remained high amid uncertainty on monetary policy. With spreads hovering above historical averages, we believe residential agency MBS provide the potential for attractive risk-adjusted returns in core and core plus portfolios. Even after some tightening in May, the Bloomberg U.S. MBS Index’s option-adjusted spread (OAS) ended the second quarter 17 basis points (bps) above its 10-year average at 51 basis points.
1. A decline in rate volatility should benefit mortgage securities
Interest rate volatility has been elevated as markets have tried to adjust for potential Federal Reserve policy moves amid softening inflation, a strong job market and a robust consumer. Nevertheless, with the Fed having raised rates by 500 basis points over the last 16 months, we believe the central bank is closer to the end of its hiking cycle, even if it does not start reversing policy by cutting rates anytime soon.
Monetary policy works with a lag, and we expect tighter financial conditions to have an impact on the economy, even if we do not enter a deep recession. As the Fed pulls back, we expect rate volatility to decline. Mortgage-backed securities tend to track rate volatility because of the housing market’s sensitivity to rates and the securities’ embedded prepayment option. (Bonds essentially get called away if the homeowner prepays the mortgage.)
As interest rate volatility declines, mortgage spreads may compress
Source: Bloomberg. As of June 30, 2023. 1 year 10 year vol measures the expected movement in interest rates (basis points) over the next year, based on swaption pricing. MBS spreads represented by the Bloomberg U.S. Mortgage Backed Securities Index option-adjusted spreads.
2. Supply-demand dynamics have improved
A large portion of MBS assets seized by the Federal Deposit Insurance Corp. (FDIC) following the collapse of some regional banks were successfully sold during the second quarter. Spreads widened on the back of supply hitting the market, but the orderly process quelled concerns about potential market disruption.
The Federal Reserve has been a net seller as it shifts from quantitative easing to quantitative tightening, reducing its holdings of mortgage securities and other financial assets on its balance sheet. Overall, the Fed and FDIC’s actions have unlocked a lot more tradable float, which in some ways, counter-intuitively, is helping to normalize this market.
Our banking analysts do not expect another avalanche of supply from regional banks — even if the economic situation gets markedly worse and we start to see more failures. Looking further out, if there are regulatory changes impacting how banks account for risk in their investment portfolios, it will probably make it harder for them to buy agency mortgage assets, especially the longer duration securities. That could create some longer term structural changes in demand, which could also be an opportunity for money managers and relative value investors like us to step in as banks and the Fed step back.
MBS spreads are at the high end of their 10-year range
Source: Refinitiv. MBS represented by Bloomberg U.S. Mortgage Backed Securities Index USD option-adjusted spreads. As of June 30, 2023.
3. Current coupon securities provide attractive carry
Nominal spreads on current coupon mortgages in the Bloomberg U.S. Mortgage Backed Securities Index (securities created from the most recently originated loans and hence carrying coupons close to prevailing interest rates), trade at a spread of about 140 basis points above Treasuries, compared to a spread of around 130 basis points in aggregate for investment-grade (BBB/Baa and above) corporate bonds.
Mortgage investors more commonly look at metrics like option-adjusted spreads (OAS), which account for the bonds’ callability and the potential impact of interest rate volatility, rather than nominal spreads. And while it is true such adjusted metrics do not look especially cheap at present, we believe rate volatility is likely to be lower than what's currently priced in the market.
If we are right, it means current coupon MBS could provide returns that are close to the current nominal spread. At these levels, given the limited credit risk (due to the implicit or explicit backing of the U.S government on agency MBS), we believe the gap between OAS and nominal spreads provides adequate compensation for the downside risk.
Current coupon securities also provide a higher coupon and yield relative to older vintage mortgage securities, which were issued when rates were much lower. A large part of the Bloomberg U.S. Mortgage Backed Securities Index consists of these lower coupon (2%-3%) bonds which do not currently offer very compelling carry (interest income). But these bonds are also typically trading well below par. This can help insulate investors from outsized downside risk. With average mortgage rates in the U.S. around 7%, their prepayment risk is low, and the negative convexity we usually see in this market should remain limited.
Negative convexity should remain limited
Source: Bloomberg. Data as of July 1, 2023. Mortgages represented by Bloomberg U.S. Mortgage Backed Securities Index.
4. MBS will likely hold up better in a risk-off market
At this late stage of the economic cycle, the full impact of monetary tightening is yet to play out. While the economy is showing resilience, we believe it is premature to conclude that we are out of the woods.
In such an environment, we believe that mortgage-backed securities that provide a high level of carry and spread are likely to hold up better than investment-grade corporate bonds given the correlation of credit to equities and other risk assets in a risk-off environment.
The fragility of the regional banks remains a potential weak link in the system. And should another bout of stress ripple through the banking system, it will likely lead the Fed to lower policy rates.
In a risk-off environment, the Fed has shown itself to be supportive of financial markets through its quantitative easing program in addition to cutting rates. Mortgages sit within what we refer to as the “circle of trust.” There could be situations in which the Fed is not willing to support the corporate bond market or equity market, but they have shown support for the agency mortgage market.
5. Pairing mortgages with a yield curve steepener
An inverted yield curve cannot last forever. Sooner or later, the Fed will start to lower interest rates as inflation cools and the job market softens. When the Fed lower rates, the yield curve typically steepens, which leads to a widening of mortgage spreads given their negative convexity.
Yield steepener positions have been largely unsuccessful this year, but we remain comfortable with their long-term potential. Despite bank stress and tighter financial conditions, the U.S. economy has stayed resilient, boosted by tight labor markets and strong consumer demand. However, growth and labor trends are softening, with leading indicators suggesting further weakness to come.
Therefore, in our view, pairing mortgage investments with a yield curve steepener position is a risk diversifier in portfolios. A yield curve steepener position favors shorter duration Treasuries over longer duration Treasuries and is designed to profit in an environment where the Fed would need to cut rates.
When the yield curve steepens, mortgages typically selloff due to concerns over prepayment risk. However, this environment may be different since the bulk of the Bloomberg U.S. Mortgage Backed Securities Index is made up of mortgages that were created when rates were very low, and hence are not as vulnerable to prepayment. As such, the negative convexity often associated with MBS would be less of a concern in this market cycle.
Bottom line
Agency MBS valuations are attractive, especially after the March banking crisis. These assets are cheap compared to historical levels, and broadly speaking, spreads have not yet fully recovered. As securities that carry an implicit government guarantee, these investments will also likely hold up much better in a recessionary environment.
Spreads could drift wider in the short term, but starting yields appear to provide a good entry point, especially among current coupon securities. The Fed’s balance sheet runoff and the FDIC’s offloading of failed bank assets have been orderly, and as these agencies step away from the market, it should result in a healthier market overall.
Bloomberg U.S. Mortgage Backed Securities Index is a market-value-weighted index that covers the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
A credit spread is the difference in yield (the expected return on an investment over a particular period of time) between a government bond and another debt security of the same maturity but with different credit quality.
Duration measures a bond’s sensitivity to changes in interest rates.
Convexity measures how a bond’s duration changes as interest rates fluctuate. Bonds with negative convexity see their duration lengthen when rates rise and shorten when rates fall. When interest rates fall, the price of a bond with negative convexity does not typically rise as much as other bonds with similar maturities, and vice versa when rates rise. Mortgage-backed securities tend to have negative convexity due to their embedded prepayment option, which allows borrowers to refinance when interest rates decline.
A yield curve illustrates the yields on similar bonds across various maturity levels (such as U.S. Treasuries). An inverted yield curve is said to occur when yields on short-term bonds are higher than yields on long-term bonds. Yield curve steepening occurs with long-term rates rising more than short-term rates, or short-term rates falling more than long-term rates.
Quantitative easing is a monetary policy action where a central bank purchases financial assets like government bonds or mortgage-backed securities in an effort to stimulate the economy.
Quantitative tightening occurs when a central bank shrinks its balance sheet by selling securities or allowing them to mature and not be replaced.
A swaption (also known as a swap option) is an option contract that allows an investor to enter into a swap contract. Swaps are derivative contracts traded primarily between businesses or financial institutions outside of exchanges, through which they exchange one financial instrument for another. It usually involves cash flows, but the instrument can be almost anything. The swaps are customized to the needs of both parties, and retail investors do not generally engage in swaps.
Par is the face value at which a bond is issued. When bonds trade well below their face value, risk is reduced as they will mature at par.
A risk-off environment is when investors become more cautious due to an unforeseen event or data point and riskier investments such as equities and credit sell off.
Tradable float refers to the number of securities available for trading as opposed to those that are held by investors and are not actively traded.
Agency mortgages are issued by three quasi-governmental agencies – the Government National Mortgage Association (GNMA) which is commonly called Ginnie Mae, the Federal National Mortgage Association (FNMA), which is generally referred to as Fannie Mae, and the Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac. Ginnie Mae operates as a government agency (unlike Fannie Mae and Freddie Mac) and its guarantees are backed by the full faith and credit of the U.S. government. MBS issued by Fannie Mae and Freddie Mac are not backed by the full faith and credit of the U.S. government, but the agencies have special authority to borrow from the U.S. Treasury.
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