Agency MBS market sentiment experienced a notable improvement in the second quarter following successful FDIC auctions from forced bank selling that attracted significant buyer interest. Performance confirms this shift, with the Bloomberg MBS Index option-adjusted spread tighter by 11 basis points and excess returns of 0.76 percent in the second quarter. We expect this momentum to continue in the third quarter as market focus shifts from the FDIC sales to the overall favorable macroeconomic environment and relative valuation.
Our long-term bull case for Agency MBS spreads revolves around a stabilization of interest rate volatility. Agency MBS still carry wider spreads than before the Silicon Valley Bank collapse in March, despite a broad market recovery. With inflation showing signs of easing, we anticipate a further reduction in rate volatility this year, which should lower the compensation required for the embedded prepayment option in Agency MBS and contribute to further spread tightening. Within the Agency MBS sector, we favor current production coupon passthrough securities. These typically have higher coupons, are priced around par, and have higher option costs embedded in their high current yield and spread. We believe they offer better total return potential as rate volatility abates. We have increased our exposure in our strategies to this profile and have added more broadly to the sector.
We see a possible headwind in the structural shift in the buyer base of the mortgage market: This year will mark the first in over a decade that neither the Fed nor banks are actively buying, which means there is a need for continued reallocation by money managers from other assets to the mortgage sector to absorb current supply volumes. These flows can be fleeting, and are likely to keep spreads more rangebound in the short term. Current spread levels, which remain attractive relative to history, and the Agency-backed nature of the sector should be enticing to crossover buyers from the corporate credit space where spreads are even tighter. This is especially true for investors who are concerned about the mounting risk of recession, during which Agency MBS tend to outperform credit-sensitive assets.
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This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.
Investing involves risk, including the possible loss of principal. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their values to decline. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
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*Assets under management is as of 3.31.2024 and includes leverage of $14.5bn. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, and GS GAMMA Advisors, LLC.