At the June FOMC meeting, the Fed established a gradual reduction of its treasury and agency holdings with initial caps of USD 6B for treasuries and USD 4B for mortgage backed securities (MBS) per month. Furthermore, the Fed will increase the runoff over time to a maximum of USD 30B per month for treasuries and USD 20B per month for MBS. Adding those numbers up, the Fed will reduce their MBS balance from roughly USD 1.8T to USD 1.0T by the end of 2021 (depending on your interest rate forecast). This reduction was somewhat in line with what the market had priced in, and gives the Fed flexibility to stop runoff if economic conditions were to deteriorate. What does this mean for mortgage valuation?
As you can see from the exhibits above, mortgage spreads on an option-adjusted basis have been steadily rising since 2016, but you can also see that Z spreads (TZV) have steadily gone down. For the investor not familiar with MBS, this sounds counterintuitive, however in a low interest rate volatility environment, this can happen. But, why does it happen? If you look at Exhibit 2 above, you will see the interest rate vega and gamma, which are measures of the change in the option cost of the instrument underlying the option (vega), and the measure of the convexity of the instrument, also known as the delta of the delta or the second derivative of the underlying option (gamma).
If you didn’t understand those last two sentences, you are not alone; in more plain English the call option an investor sells when owning MBS has been going down in cost. And the rate of change in price of that call option has likewise gone down to the lowest levels seen over the past 10 years.
Bringing the discussion full circle means that absolute spreads can go down, but option adjusted spreads can go up as proven over the past year.
Now to the point, it’s the classic bulls versus bears argument, are mortgages cheap or rich? A bull may say mortgages are cheap relative to all other asset classes, as most asset classes are at their tightest spreads over the past few years. Some bulls may mention the OAS steadily rising as a sign of value. Additionally, bulls may point to the fact that money managers have bought USD 60B in outright agency MBS YTD, or that foreign buyers see agency MBS as the highest yielding government guaranteed asset class.
The bears will make the case that the mortgage basis (spread above similar duration treasury blend) is at the tightest levels since late 2012 and OAS is at the tighter end of the range since 2003. Bears may also state that correlations are ever-increasing between treasuries and MBS, following the path of past rate hike cycles that could potentially widen the basis. More headwinds include the largest buyer (the Fed) stepping back, and potential increases in interest rate volatility, increasing vega and gamma, which in turn widens MBS spreads.
As of right now, we look at the underlying fundamentals, combined with a difficult technical backdrop, and feel there could be a better entry point. With plenty of investors on each side of the fight, tapering will create a dynamic second half of the year in MBS no matter what side of the argument you are on.