With year-to-date excess returns of 30 bps versus similar-duration Treasury securities*, Agency Mortgage-Backed Securities (MBS) may get overlooked as an attractive asset class. But the following are some reasons why not to forget about Agency MBS in a fixed income portfolio.
Macro fundamental outlook remains favorable
Our Global Fixed Income, Currency & Commodities (GFICC) team recently completed their Investment Quarterly strategy-setting meeting to debate the outlook over the next three to six months. The output of this meeting was an expectation for “more of the same”: below-trend growth, with disinflationary forces in place, and central bank accommodation continuing to drive markets. These conditions should continue to create a positive fundamental environment for investing in Agency MBS.
For example, an important driver of valuations for Agency MBS is interest rate volatility, which factors into the pricing of prepayment risk. Volatility, measured by actual changes in yield or an estimate of future yield changes as implied by an option model, can be a tailwind for Agency MBS investors when it is low, by keeping mortgage lending rates stable and by reducing hedging costs.
In terms of realized volatility, the current environment has been very friendly for mortgage investors, with the 10-year Treasury yield consolidating within a 27 bps range since mid-July. Estimates of future volatility also remain supportive of valuations, with short-dated implied volatility falling just last week to its lowest point since 2014 as the Bank of Japan and the Federal Reserve each reaffirmed their accommodative stances. Our outlook would suggest that this low interest rate volatility environment should continue for the foreseeable future.
Consistent with the theme of continued central bank accommodation, the Fed has repeatedly committed to continue reinvesting the principal of its $1.7 trillion in Agency MBS holdings “until normalization of the level of the federal funds rate is well under way.” With the Fed’s forecasts for the future path of rate hikes decelerating even further following their September meeting, the timeframe for any change to their Agency MBS reinvestment program continues to be pushed back further.
It’s all about the technicals
The backdrop of favorable macro fundamentals has created a positive environment for Agency MBS technicals, which we expect to be the main driver of returns for the sector in the near term. Specifically, the yield advantage of Agency MBS is attractive versus similar-duration Treasuries, particularly as the Treasury curve has flattened, empirical durations have fallen and rates have remained range-bound. In addition, the investor base for the marginal buyers of Agency MBS is well diversified. The favorable carry profile and capital treatment of Agency MBS has led to strong demand from overseas investors and banks, which we believe will continue. And as mentioned above, the Fed’s reinvestment program is also supportive of the sector. Furthermore, Agency MBS continues to be highly liquid, with an average daily trading volume of $206 billion year to date, second only to Treasuries and 6 times that of corporate bonds.
Putting valuations in context
While Agency MBS spreads may look tight by some measures, MBS returns have lagged other spread sectors year to date and going forward should benefit from relative valuations. Historically, Agency MBS investors have often looked to option-adjusted spreads, which are now flat to negative for low coupon mortgages. However, with hedging costs so low, duration-hedged carry on 3% coupon Fannie Mae 30-year MBS, at 5 ticks per month, is at its highest level in four years.
The place for Agency MBS in a portfolio
With positive technicals creating opportunities for investing in Agency MBS, it is worth noting that the Agency MBS sector offers the highest returns per unit of risk relative to other investment grade fixed income sectors on an index basis. [See chart below]
Given our strategic outlook and the strong technical environment, we expect Agency MBS to continue to add value to client portfolios.