US mortgage-backed securities look attractive now relative to government bonds. Headwinds in the form of, for example, rising central bank rates and higher market volatility are abating. This environment should see a rise in demand from yield-oriented buyers and financial institutions.
Mortgage-backed securities (MBS) are a large component of the bond universe: they make up about 12% of the global bond market and about 23% of the US bond market (source Bloomberg). That size means liquidity is deep. The market for agency MBS – bonds issued by US agencies – is one of the most liquid in the world, with USD 250 billion trading a day on average as of June 2023 (source Agency Trading).
MBS yields have risen because the home loans banks issue now come with higher coupons in the wake of the US Federal Reserve raising official interest rates sharply in its fight against inflation.
While the Fed’s action may have fanned market concern about recession or an economic slowdown in the US, MBS’s credit quality is generally high. We note that bonds issued by Ginnie Mae are explicitly US government guaranteed and Freddie Mae and Fannie Mae have been backed implicitly by the full faith and credit of the US Treasury since September 2008, making the risk of default of these US housing agencies virtually as low as that of US Treasury bonds. It must be said that issuers other than US agencies also issue MBS.
We believe that high credit quality, high liquidity and high coupon income offer investors an attractive opportunity with effectively (and historically) no or only little credit risk. Looking at spreads over other classes of fixed income, we expect corporate bond spreads to widen materially over the next 6-8 months as the economy slows and issuers feel the pinch. Even if mortgage bond spreads stay unchanged, the carry alone should allow agency MBS to outperform other spread sectors.
What about the headwinds?
This year, the asset class has faced obstacles to performance including limited bank demand, asset sales by defaulted banks and the Federal Deposit Insurance Co, an inverted yield curve favouring investments at the short end of the curve, and higher market volatility as yields rose.
However, we see that these headwinds are now dissipating.
- MBS supply has been anaemic at less than a sixth of the average over the past three years
- Asset sales in the wake of the US regional bank crisis have ended
- With the Fed largely done raising interest rates, the yield curve has steepened
- Demand from money managers has increased/they have raised their overweight positioning
- Fund flows have been positive for fixed income and MBS funds
- Market volatility has started to come down.
We believe global financial conditions and the prospects for investors in the asset class are more appealing now than they have been for several years. We see current entry yields as the most attractive since the Great Financial Crisis and believe this bodes well for future returns.
In more detail:
1. MBS spreads look cheap to us, with current coupons at 170bp over nominal US Treasury bonds1 (see exhibit 1).
2. MBS Index metrics are at historic levels:
- The average dollar price of the index is USD 86
- Index convexity is 0
- Index OAS stands at +48 for a government-guaranteed asset with virtually no credit risk.
A bright outlook
We believe mortgage loan spreads look attractive at current levels and represent a significant opportunity for investors: spreads on new mortgages exceed 160bp, while coupons on new mortgages are a hefty 5.5-6.5%. The carry alone relative to US Treasuries or corporate bonds looks attractive, but if spreads tighten over the medium term, total returns should be strong. Risks to the outlook are centred on higher market volatility which would likely reflect uncertainties over monetary policy, a slowdown in growth, or an eventual recession.
With the Fed now less involved in this part of the fixed income market, we see more scope for active management and finding alpha-generating opportunities.
We are overweight MBS versus US Treasuries. As the Fed completes its current hiking cycle, market volatility should fall further, and the yield curve should return to a positive slope. Both developments should benefit MBS and create demand from yield-based buyers and banks.
As issuers of MBS, regional US banks faced a risk management crisis unrelated to the asset class. Liquidations of bank assets as a result of the crisis can be seen as an opportunity. Given the healthy demand and orderly market absorption, the selling should finish soon.
[1] For US agency MBS, the Treasury market is often used as a benchmark. Nominal spread or WAL spread is the yield differential between a mortgage security and a benchmark interest rate security with a maturity matching the weighted average life of the MBS. The Current Coupon Rate is the coupon of a hypothetical par-priced mortgage bond, i.e., an estimate of the prevailing secondary market mortgage rate.
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