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Episode 77: Agency MBS: From Zero to Hero
For two decades, we typically looked past Agency mortgage-backed securities (MBS) to find better relative value opportunities in the non-government sponsored credit markets. But something fundamental changed, and over the past three years these securities have claimed an increasingly significant allocation in our total return strategies. What sparked this pivot? Portfolio Manager Adam Bloch and Louis Pacilio from our Structured Credit team unpack the mechanics of the Agency MBS market, explain what shifted in the risk-reward equation, discuss the future of Fannie Mae and Freddie Mac, and explore the opportunity going forward.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I’m Jay Diamond, head of thought leadership for Guggenheim Investments and I'll be hosting today. Now, one of the most important features of the U.S. housing finance system is the role played by the government sponsored enterprises Fannie Mae and Freddie Mac, and the government agency Ginnie Mae. The $9 trillion in mortgage-backed securities that they guarantee, which are collectively called Agency mortgage-backed securities, or MBS, is nearly as big as the corporate bond market, making it an integral part of the fixed income asset managers toolkit. What are the investment characteristics of the Agency MBS market? What role do they play in a portfolio? And what's next for Fannie Mae and Freddie Mac? Well, this will be our focus today on Macro Markets and helping us to answer these questions are Adam Bloch, Managing Director and Portfolio Manager on our total return team, and Louis Pacilio, a director on our structured credit team who focuses on the Agency MBS sector. So, Adam and Louis, thanks for taking the time to chat with us today.
Adam Bloch: Thanks for having us, Jay.
Louis Pacilio: Yes, thanks. Great to be here.
Jay Diamond: All right, Adam, let's begin with portfolio management basics. What is the role that is typically played by Agency MBS in our portfolios?
Adam Bloch: Sure. So Agency MBS could serve a couple of purposes. It can be a liquidity tool, adding spread in excess of Treasurys on the portfolio’s liquidity bucket. It can also be a tool to help manage credit beta. So it gives us an opportunity to add high quality credit beta if spread levels are broadly attractive in the market, but if we want to be cautious on adding, particularly credit sensitive risk. And more recently, the past couple of years, it's been a significant source of alpha generation.
Jay Diamond: So, Adam, when we discussed what we were going to be covering on today's podcast, you said that you wanted to talk about Agency MBS. Why is that?
Adam Bloch: So for the first 15 years of our total return strategies history, we had nearly zero exposure or allocation to the sector. Over that period, the Fed was a significant buyer. In the years following the global financial crisis, that kept spreads very tight and relative value opportunities pretty limited in the Agency MBS space. Simply put, we had better opportunities elsewhere in other parts of the credit market. Then 2022 happened. The Fed raised the overnight rate to over 5 percent by mid-2023, started cutting back on quantitative easing quite significantly, and accordingly interest rate volatility spiked and hit levels we hadn't seen since the global financial crisis. All of that created a significant opportunity for Agency mortgages, an opportunity to generate alpha and not just excess carry versus Treasurys. And so accordingly, we've now seen that allocation grow from 0 percent in our total return strategies to nearly a third of our core plus strategy, as an example. So, we thought it would be an important place to spend a little bit of time.
Jay Diamond: Louis, with that as a starting point, let's level set on the securities themselves. What are Agency MBS?
Louis Pacilio: Sure. So let's start at the beginning. So the process begins when a home buyer obtains a mortgage loan from a lender and uses the home as collateral. So to free up capital for additional lending, lenders then bundle mortgages with similar characteristics together and sell these pools of loans to investors as mortgage backed securities. The defining feature of the Agency MBS market is the government guarantee of the timely payment of principal and interest. This effectively removes credit risk and enhances the appeal to investors. Now, it is important to note here, only mortgages that meet specific borrower property and loan criteria qualify as Agency eligible. So not all loans are receiving government backing. The vast majority of Agency backed loans are 30-year fixed rate mortgages. A smaller segment consists of 15-year fixed rate loans, which feature a shorter amortization period and are commonly used for refinancing existing 30 year loans. And then lastly, hybrid adjustable rate mortgages or ARMs can also receive agency backing. These products are predominantly issued through non-Agency channels or retained on bank balance sheets, so are a much smaller piece of the market. So in general when investors refer to Agency MBS, they are referring to securities that are backed by 30-year fixed rate mortgages.
Jay Diamond: So as follow up Louis, what are their benefits and their risk profile?
Louis Pacilio: So a 30-year fixed rate mortgage provides a borrower with a uniform monthly payment throughout the term of the loan and it allows for a penalty free prepayment at any time. So in practice very few borrowers retain their mortgages for the full 30-year period. On average, the lifespan of a 30-year mortgage ranges from 8 to 12 years. Borrowers can prepay for various reasons, whether they're market related or non-market related. And this prepayment risk is the primary risk for which investors are compensated when purchasing Agency MBS. Since the government guarantees the credit quality of the mortgage pool, the question for investors is not whether they will receive their principal back at par but when. Investors are effectively compensated for being short this prepayment option held by borrowers. Now, the main incentive to refinance is rate incentive. So this creates an asymmetric outcome that favors borrowers over investors, which gives rise to a phenomenon known as negative convexity. And I'll give a quick example of this to illustrate this. When interest rates fall or bonds rally, borrowers can refinance into lower mortgage rates. The duration shortens on mortgage bonds and price appreciation is limited as prepays come at par. This is contraction or call risk for the investor. Conversely, when rates rise or sell off, borrowers retain their favorable existing mortgages. Duration extends on mortgage bonds and price depreciation accelerates. This is extension risk for the investor. So to compensate investors for these contraction and extension risks, Agency MBS traded a positive spread and higher yields compared to similar duration U.S. Treasurys. This spread and yield premium, due to the negative convexity embedded in mortgages, represents the primary appeal of the sector. And as touched upon in this example, Agency MBS really function as an expression of short interest rate volatility. Mortgage bonds perform best in a range bound rate environment, which allows investors to fully capture this excess spread over Treasurys without any significant prepayment driven disruptions.
Jay Diamond: Is there any difference in the characteristics or trading patterns between Fannie Mae, Freddie Mac, and Ginnie Mae mortgage-backed securities?
Louis Pacilio: Fannie Mae and Freddie Mac operate under very similar structures, and they've been under government conservatorship since the global financial crisis. These two are referred to as government sponsored enterprises, or GSEs, and they provide an implicit government guarantee. This means that the government backing is assumed during times of crisis, but not legally mandated. Both agencies are regulated by the FHFA or the Federal Housing Finance Agency, and are commonly referred to as conventional mortgages. Now, Ginnie Mae differs fundamentally by offering an explicit government guarantee. Their securities carry the full faith and credit backing of the U.S. government, similar to U.S. Treasurys. The explicit government backing of Ginny Mae Securities provides favorable capital treatment for banks and enhanced appeal to overseas investors. Now, for asset managers such as Guggenheim, we do not face the same regulatory considerations as banks. And as a result, we generally prefer conventional loans backed by Fannie Mae and Freddie Mac. Conventional mortgages typically exhibit a more stable and predictable cash flow profile compared to genuine loans and this makes them more suitable for investment portfolios focused on capturing spread and cash flow stability.
Jay Diamond: Let's talk about technicals in the Agency MBS market. To begin, what drives issuance of Agency MBS?
Louis Pacilio: So to cover this question, let's start with the two main supply metrics. First is gross issuance, this is a measure of total market activity. Gross issuance represents the total volume of mortgage-backed securities issued, which includes both refinancing activity and new home purchases. This metric generally increases when interest rates decline, spurring refinancing activity, and new home supply expands, generating purchase mortgage originations. The second measure is net issuance, and issuance is a more meaningful measure for investors and it calculates the net change in the overall MBS universe. This is derived by subtracting existing mortgage balances that are paid off from gross issuance. Now, net issuance is less sensitive to refinancing activity and more dependent on new home supply and home price appreciation, which allows for increased mortgage balances on existing homes. Net issuance is also heavily influenced by securitization rates. Now, this is the proportion of originated mortgages that lenders choose to securitize versus retain on their balance sheets. This last factor is a bit of a wild card, as changes in bank securitization behavior are very difficult to predict. The current market is characterized by relatively low net issuance, and this has been driven by stagnant home prices and constrained new home supply. So this low net issuance environment represents a technical tail one for Agency MBS, as limited supply lowers the bar needed from the demand side of the equation to tighten mortgage spreads.
Jay Diamond: Finally, who are typically the major buyers of Agency MBS?
Louis Pacilio: The substantial size of the Agency MBS market attracts a broad spectrum of institutional investors. It includes banks, asset managers, overseas investors, insurance companies, pension funds, mortgage rates, and hedge funds, to name a few. Now, the top three private sector holders of funds are banks, money managers, and overseas investors. Banks represent the largest investor group of Agency MBS. They hold approximately one third of the MBS universe. Bank investment portfolios consist primarily of U.S. Treasurys and Agency MBS, which provide excess spread over their funding costs when the yield curve is upward sloping. This spread differential makes Agency MBS an attractive asset for balance sheet optimization. Asset managers constitute another major source of demand, driven largely by benchmark considerations. Most fixed income managers are benchmarked against the Bloomberg U.S. Aggregate Bond Index, of which Agency MBS is approximately 25 percent. This creates a steady passive bid for Agency MBS when investors are allocating to fixed income. Money manager demand is also influenced by relative value dynamics versus other aggregate index components, particularly corporate bonds. And lastly, overseas investors seeking U.S. fixed income exposure represent another significant player in the market. The explicit government guarantee Ginnie Mae MBS provides an attractive option for foreign central banks and institutional investors.
Jay Diamond: Thank you for all that background. Now, Adam, one major buyer that Louis didn't mention is the Federal Reserve. Can you give us a bit of the history of the Fed using MBS as part of their so-called quantitative easing and quantitative tightening programs? And how is this intended to affect the market?
Adam Bloch: Oh, boy. A fun walk down memory lane there. So during the GFC or immediately post financial crisis, the Fed bought call it a $1.25 trillion of Agency mortgages. The market back then was maybe 5 to $6 trillion. So that was a pretty significant intervention obviously, given the exceptional, circumstances the market was facing. Fast forward a few years, we had QE three that started in 2012. That's another trillion-ish, just under a trillion of buys. And then the Ded added another $700 billion or so during the pandemic in 2020. Market size today is around $9 trillion, as you mentioned at the outset, Jay. So each of these interventions was incredibly significant. Those interventions had the option-adjusted spread or the spread kind of net of market assumed prepayment risk near zero for most of the post GFC era. That spread today is in the 30 to 40 basis point range. So the combination of QT and rate increases, as mentioned over the course of 2022 and 2023, caused spreads to blow out to levels not seen since the GFC. So watching the Fed is incredibly important as we think about participating in this market.
Jay Diamond: At its last FOMC meeting, the Fed announced it was stopping its balance sheet run off. Does this have any impact at all on the Agency MBS market?
Adam Bloch: Not per se. Again, the change here was on the balance sheet, not their interaction with the Agency MBS market directly. So, you know, more than thinking about the next technical shoe to drop, so to speak, it's banks reentering the market as deregulation evolves. We know that continues to be a major priority for the presidential administration. And then the Fed potentially becoming a buyer again if we see a need for financial conditions to ease that. That's the main point of them ending their balance sheet runoff is potentially unlocking further capacity to regrow the balance sheet if at some point economic conditions necessitate that. So we're not betting on that happening necessarily. Or even the banks becoming big buyers, though we do think their involvement is going to become more and more going forward. But more importantly is how we think about the balance of risk. So right now, you know, the Fed's not going to be stepping back from the MBS market much further than their current pace. We know they're not going to be shrinking the balance sheet anymore. And so kind of knowing that a ceiling is in on the runoff is incredibly important and that should similarly put a ceiling on how wide spreads could go in a risk off environment.
Jay Diamond: So before we get to portfolio allocation choices and what we like, Louis, tell us a little bit about how the market is organized.
Louis Pacilio: Sure. So Agency MBS are issued in coupons with 50 basis point or a half percent increments. And as interest rates move around over time, the coupon on new issue bonds adjusts accordingly. And this has created a market where the 30-year Agency MBS options trade across a very wide range. So we now have coupons as low as 1.5 percent to as high as 7 percent. This menu of investment options is referred to as the coupon stack, and this results in mortgage bonds with varying dollar price, duration profiles and convexity risk. This allows Agency MBS to appeal to a broad spectrum of investors, enabling them to tailor sector exposure that aligns with their macro views and risk preferences. One important dynamic worth highlighting here is the discrepancy between the current mortgage rate and the bonds that make up the MBS index. With current mortgage rates just above 6 percent, newly issued mortgage bonds that are priced near par have coupons of 5 percent and 5.5 percent. In contrast, the Bloomberg U.S. MBS index consists of bonds with an average coupon of 3.5 percent, a low 90s dollar price, longer durations, and much lower negative convexity profiles than new issue bonds. This is because the underlying borrowers on these bonds are well out of the money, with little incentive to refinance at current rates. So, as compensation for their less favorable convexity profile, new issue bonds offer much wider spreads and higher yields compared to the MBS index. Discrepancies like this are where active management can really generate meaningful alpha in Agency MBS. Now once coupon stock positioning is determined, investors must choose between TBA or “to be announced futures” contracts or settled mortgage bonds known as specified pools. TBA contracts are monthly futures contracts that specify the agency, Fannie, Freddie or Ginnie, the term 30-year or 15-year and the coupon. And TBAs do offer superior liquidity, so compared to specified pools, the liquidity is much better as the majority of trading occurs in the TBA market. Now moving to specified pools, these consist of mortgages with specific underlying loan characteristics or stories that offer favorable convexity profiles. This means that these bonds either limit the extension risk, the contraction risk, or both. These characteristics may include loan size, loan age, or borrower profile. Specified pools do trade at a payout or premium to TBA contracts, and this reflects their superior convexity, as we mentioned. So because of this pay up, the investor gives up some spread and yield in return for a more stable cash flow. Over time, different rate environments drive shifting preferences between TBAs and specified pools. In a high prepayment risk environment, now tying this into current market conditions throughout the first half of the year, investors favored TBAs as prepayment concerns were contained. Since late summer though, positioning has notably shifted toward specified pools as mortgage rates are now at their year to date lows. This rotation reflects active managers’ efforts to protect portfolios against prepayment risk while maintaining spread income.
Jay Diamond: Now, Louis, I've heard talk about collateralized mortgage obligations or CMOs. Can you discuss this part of the Agency market?
Louis Pacilio: Sure. So CMOs are structured securities that redistribute prepayment risk, and they're redistributing the prepayment risk of an underlying group of specified pools across multiple tranches. This structural flexibility allows investors with specific duration, cash flow, or risk preferences to get tailored exposure to the sector. Now, as with any structured product, the attractiveness the CMO begins with the underlying collateral. When specific segments of the coupon stack trade at wide spreads, issuance using that collateral typically increases. In the current market, premium coupon bonds are the cheapest on the coupon stack due to heightened prepayment concerns. Because of this, they are the most popular collateral for CMO deals. Market participants can capitalize on this dynamic by structuring CMOs that limit the same prepayment risk that is driving the cheapness of the collateral.
Jay Diamond: Great. Now, Adam, I want to dive into something that you mentioned at the top of the podcast, which is that, you know, over the last year or two, we've been allocating more capital in our portfolios to Agency MBS. So repeat for me, why have we been making that move?
Adam Bloch: So again, it's the kind of one two punch over 2022 and 2023 of the Fed raising rates, beginning quantitative tightening to remove stimulus from financial markets, and that one two punch caused interest rate volatility to spike. As Louis talked through, you can think about Agency mortgages as very, at their most simplistic fashion, as a vol selling instrument. So as volatility rose, that worked against the market, caused spreads to widen, basically caused investors to demand wider spreads and higher yields to compensate them for that cash flow uncertainty that that Louis talked about earlier in the podcast. So that caused spreads to back up. You know, we got to basically global financial crisis levels, which again created an opportunity for us to get more involved in the sector and ultimately made spreads look pretty attractive relative to other parts of the credit markets that were typically more focused on.
Jay Diamond: Where are you choosing to allocate capital among the different options and coupons stack and security types that are in the market?
Adam Bloch: So most of the focus has been on pass throughs. And over the course of most of the year, we've been focused on the current production coupon part of the market. So call it five and a half to 6 percent in a couple periods, 6.5 percent coupons. That's the part of the market where you get the highest yields, because again, you need to be compensated for potential refi risk, that cash flow uncertainty we talked about. Our macro view over the course the last couple years has been for long end rates, interest rates, to remain relatively rangebound amid this kind of push and pull of a weakening labor market, but persistently higher inflation. So that helped us to get comfortable with lower prepayment risk relative to market expectations, which made those higher coupon pools or mortgages look more attractive to us. At one point earlier this year, the outperformance of that part of the market, the current coupon part of the MBS market versus the low coupon part of the market was about 1 percent. That's enormous when you consider it's all the same credit risk. Then over the summer, we saw economic data weakening, political pressure turned up on the Fed and this caused us to shift a pretty large chunk of our MBS exposure to the lower coupon parts of the market. Call it the 3 percent coupon structures where prepayments aren't particularly rate sensitive. A few weak economic data releases and the drought of economic data we've had amid the government shutdown for the past six or so weeks, helped drive those lower coupon bonds to outperform by nearly 1 percent. Again, a pretty mind-boggling move given it's all the same credit risk.
Jay Diamond: And so what is your outlook for the sector from here?
Adam Bloch: Overall, we still think the sector looks cheap versus other credit markets on an option adjusted basis again which incorporates the market assumed risk of prepayment. You're only giving up about 50 basis points of spread to own an Agency guaranteed pool of mortgages versus investment-grade corporates. Post global financial crisis that relationship is averaged more like a 100 basis point difference in spread between MBS and IG. So there's definitely more room for MBS to tighten relative to corporates. And with rates having now reset lower, we think the rangebound rate environment is here to stay, albeit at this lower rate level, at least until we get through some of this tariff induced inflation spike. And that may well take some time to resolve itself. So now kind of once again, back to where we were earlier in the year, current coupon mortgages, that's now more like 5 percent coupon pools, are attractive again. Again as a way to capture that premium associated with the prepayment risk.
Jay Diamond: Finally, how do you see the housing market performing?
Adam Bloch: So there's still a massive supply problem in housing. Louis and I were talking about this quite significantly yesterday. Estimates range from anywhere from 3 to 8 million too few homes in the U.S. So a lot more homes need to be built to kind of balance out that supply demand mismatch. So as rates stabilize, potentially move a little bit lower, that generally unlocks more demand. It brings buyers in and off the sidelines. So as those increased buyers kind of collide with still an undersupplied market, the fundamentals and technicals for the housing market remain very supportive.
Jay Diamond: Now, Louis, as our point man, as it were, on the Agency MBS market, are there any other factors that you are looking at when analyzing the sector, and how would you characterize the market right now?
Adam Bloch: Yeah, so as Adam referenced, the current spread levels of Agency MBS, particularly our coupon, or production coupon MBS, are still at historically cheap levels. And this is really notable given that investment-grade corporates, the primary fixed income competitor for Agency MBS, are trading near all-time tights. So this has led to money managers capitalizing on this relative value opportunity, becoming the primary driver of sector demand. So what we're looking at is now, is what will it take for Agency MBS to close the gap versus comparable spread products. We believe renewed bank participation will be the key catalyst here. So year to date, banks have favored Treasurys over Agency MBS in their securities portfolios, resulting in net reductions of Agency MBS holdings. However, looking forward, we anticipate this dynamic to potentially shift with further Fed rate cuts, the end of QT, and an additional regulatory relief. Such a shift would represent a significant change on the demand side of the equation. And as we said, this is against the backdrop of manageable net supply on the other side of the equation. So overall, we remain optimistic on Agency MBS going forward, both on an absolute and relative value basis.
Jay Diamond: Thank you both for all of your time and sharing your thoughts with us today. But I can't let you go without referencing the dynamics of Fannie and Freddie and, Adam, you know, the administration has said that it is opportunistically evaluating taking Fannie and Freddie public as early as the end of this year. First of all, what would this look like? And second, do you expect this IPO to happen and on this timetable?
Adam Bloch: So two key points here and it's a very fascinating topic. But maybe before we even get into that, at the outset, I think it's very important to point out to listeners that none of what we're going to discuss here related to Fannie and Freddie privatization or potential IPO has much of anything to do with mortgage spreads. So, the investment thesis we talked about is more or less unaffected by what we'll talk about here. But two key points to related a privatization or IPO. So one, this is a recap and retain, not a recap and release. The GSEs are profitable for the government, so there's kind of limited incentive to fully release them. But a capital raise is good publicity and, you know, brings in some new money and dry powder while allowing the government to retain control. Fully releasing the GSEs would probably take several years of building up kind of a retained earnings track record and history that would likely take us beyond the scope of the current administration. And then the second point is that current political winds have shifted a bit to focus more on affordability. So that shift to affordability is somewhat at odds with the increased profitability needs of the GSE that would come prior to an IPO. So if the administration has to kind of pick a lane here, we think it'll most likely focus on affordability over improved GSE profitability particularly with the midterms coming up next year.
Jay Diamond: This is also perhaps somewhat of a political question. But what's your view on the 50-year mortgage?
Adam Bloch: Start running the math out on that and it doesn't seem particularly borrower friendly. I could see where the banks could get a lot of interest out of that. You know, listen, there's a lot of debate in the political realm and on Main Street about how to fix the housing crisis and I kind of alluded to it earlier, but the problem continues to be on the supply side. It's not a demand problem. We've come well off the highs and rates that were potentially constraining demand. We're seeing pretty significant activity on the housing side. But there's just not enough homes. So you know, you can make it a 100-year mortgage and it's not really going to change the fact that we have a significant supply shortage that exists in the market right now. And the same can be said for proposition of mortgage portability as well. You know, all these things may help at the margin, but it's not changing the dynamic whole scale.
Jay Diamond: Well thank you for that. And again, thank you guys for your time. Before I let you go, Adam, do you have any final takeaways that you would like to leave with our audience?
Adam Bloch: So we talked about it earlier, but MBS, mortgage-backed securities, can be a source of alpha, not just a liquidity tool, though, can certainly accomplish both goals. So I think we've had an excess return range of 2 percent between two different parts of the market, that high coupon or current coupon part of the market and the low coupon part of the market is pretty significant and ultimately just reaffirms that with the elevated volatility backdrop we currently have, MBS continues to be a compelling place to be invested. And probably most importantly, active management is absolutely essential within this market. This can't just be a set it and forget it allocation. You really need people that are smart, focused, and have the experience and knowledge within that market to enact this strategy within a multi-sector framework.
Jay Diamond: Thank you and Louis. Any final thoughts from you for our listeners?
Louis Pacilio: Yeah, sure. I would just echo what Adam just said. I mean, if there's really one major takeaway here, you know, Agency MBS is a sector that really lends itself to active management. We touched on several examples of this throughout our conversation. The multitude of options across the coupon stack, the discrepancy between the index and the current mortgage rate, TBAs vs. specified pools and structured CMO cash flows. There's a lot of out of index investment opportunities that allow managers to allocate funds to the sector, which enables them to optimize their exposure and really customize it to their macro views and any specific investor needs.
Jay Diamond: Again, thank you guys so much for your time. Adam and Louis, please visit again with us soon. And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please follow us. And if you have any questions for Adam or Louis or any of our other podcast guests, please send them to MacroMarkets@GuggenheimInvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond, and we look forward to gather again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, visit GuggenheimInvestments.com/perspectives. So long.
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