Much like in the first quarter, mortgage spreads underperformed in the second quarter as uncertainty over inflation and the Fed response boosted rate volatility and kept most mortgage buyers on the sidelines. Option-adjusted spreads ended the quarter at 46 basis points, 22 basis points wider quarter over quarter. The Bloomberg Barclays U.S. MBS Index second quarter total and excess returns were -4.01 percent and -0.98 percent, respectively. In contrast, Agency CMBS posted second quarter excess returns of 0.50 percent. Overall, the Agency multifamily sector has benefitted from a better convexity profile, capped issuance and reduced Fed dependency compared to the single-family sector.
The main event in the second quarter was the decision by the Fed to speed up the pace of monetary tightening. In addition to rate hikes, questions around the timing and scale of potential Fed sales of its mortgage holdings added another unknown for mortgage investors to digest. This resulted in a spike in both realized and implied rate volatility and weighed on the sector, with nominal spreads the widest since 2008 excluding the initial COVID selloff. Despite this negative backdrop, some positive developments are presenting themselves. With almost the entire mortgage-backed securities universe out-of-the-money to refinance and slowing home sales, net supply forecasts continue to be revised downward. Additionally, higher rates will make the scheduled Fed runoff more manageable and well below the terminal $35 billion per month cap. These two positive factors may make it worthwhile to increase exposure to the sector, given the historically wide nominal spread levels. A drop in rate volatility will be needed for sustained outperformance, but this is something we do not recommend trying to time given the typical rapid speed of repricing in the sector.
Against this backdrop, we favor investments in which either the collateral or structure offers some cash flow stability to buffer against potential continued elevated rate volatility. We find select subsectors, including off-the-run Agency CMBS, low-pay up specified pools, and locked-out collateralized mortgage obligation (MBO) structures, attractively priced in the current environment. We believe that these investments should provide cash flow certainty in the current rate environment and continue to benefit when the market focus returns to cash flow fundamentals.
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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. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-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 risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk.
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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 Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.