Are Agency Mortgages a Home Run?

Why we think recent banking-sector stress has made already attractive U.S. mortgage securities even more keenly valued.

In our Fixed Income Outlook coming into 2023, we raised our view on U.S. agency mortgage-backed securities (MBS) to a meaningful overweight.

Prices did rise over the first quarter of the year, but spreads widened not only against U.S. Treasuries, but also against other investment-grade fixed income assets. In our latest Outlook, however, we have stuck to our positive view—indeed, we now hold it with even greater conviction.

We’ve written a lot about the fallout from recent banking-sector stresses. In our view, the attractive value opportunity in U.S. mortgages is one of the most interesting parts of that story.

Aggressive

It’s been many years since U.S. MBS were attractive.

By April 2021, the U.S. Federal Reserve’s pandemic quantitative easing program had driven spreads close to zero. A year later, the Fed stopped that program and made the first of its aggressive series of rate hikes, as inflation took hold.

By October of last year, this had sent the Bloomberg U.S. MBS Index from a 2020 high of $107 to a low of $85. That was equivalent to an option-adjusted spread of almost 90 basis points over U.S. Treasuries, and some 20 basis points over the Bloomberg U.S. Aggregate Index.

The MBS Index then outperformed the rest of the investment grade universe for three months. Markets were increasingly pricing for a peak in Fed policy rates, investors started bidding for those attractive spreads and new, “current-coupon” MBS were being originated at close to par pricing with rates of 5% or 6%.

In addition, one of the key risks generally faced by mortgage investors had effectively disappeared.

Repayment Risk

With agency mortgages, the key risk involves prepayments: early or faster-than-scheduled repayment. In normal circumstances, this erodes both the annual carry the investor earns from the asset and the ultimate yield to maturity.

There are lots of reasons why borrowers repay or overpay their mortgages. Sometimes they will be incentivized by higher rates (to save money in the long run), sometimes by lower rates (to refinance more favorably) and sometimes by other factors (such as moving home).

On balance, however, attractive refinancing options and busier housing markets mean that early payments are more common when rates are low and falling. When rates are high and the housing market is slowing, like they are now, borrowers tend to repay on schedule—decreasing investors’ prepayment risk.

Moreover, in the current environment, even when they do repay, the impact is actually positive, not negative. That’s because older mortgages issued during the quantitative-easing era are still trading at discounts (the MBS Index sits at around $91), but the borrower repays the par value.

In other words, when rates are this high and agency MBS are trading at these unusual discounts, investors not only have extra confidence about the lower end of their potential yield, but the prospect of substantial upside should early repayments come in even marginally faster than what is priced in.

Alongside the newer, par-priced bonds with their 5 – 6% coupons, this means the MBS market is currently offering two distinct, and in our view distinctly attractive, investment opportunities.

Fire Sale

And yet, since February, the U.S. Aggregate Index spread has widened by 12 basis points and the MBS Index spread has widened more than twice as much, by 27 basis points. It is yielding 4.5%, still close to its all-time high.

We think the bulk of this is due to banking-sector stress—and particularly liquidity concerns across regional U.S. banks.

Faced with depositors seeking out higher rates from competitor banks and money market funds, or looking to get individual deposits below the insurance threshold—or just acting a little more skittishly following the recent headlines—many banks have been selling high-quality assets to meet withdrawals or enhance their liquidity. Mortgage loans and MBS have been prominent in the fire sale.

Might this extend the period of volatility in the asset class? For sure. We knew the Fed had withdrawn as a buyer, and now we have an unknown number of new sellers.

In our view, however, that just extends the opportunity to buy these assets at unusually wide discounts. And those discounts are especially attractive when, as last week’s relatively benign U.S. inflation data suggests, central bank policy rate volatility may be easing and investor demand for higher-quality fixed income may be about to rise.