Agency Mortgage-Backed Securities: Fed Leads the Way

This Agency Mortgage-Backed Securities sector report is excerpted from the First Quarter 2021 Fixed-Income Outlook.

Mortgage spreads continued to tighten over the fourth quarter as the Fed and heavy bank demand offset prepayment concerns due to mortgage rates hitting all-time lows. Option-adjusted spreads ended the quarter at 41 basis points, 22 basis points tighter quarter over quarter and effectively unchanged year over year.

The Bloomberg Barclays U.S. MBS Index fourth quarter total return and excess return were 0.22 percent and 0.34 percent, respectively. Agency MBS 2020 total returns totaled 3.84 percent, which lagged all other subsectors of the Bloomberg Barclays U.S. Aggregate Index. Notably, Agency CMBS—which offer better convexity and capped issuance—posted fourth quarter and 2020 total returns of 0.50 percent and 8.92 percent, respectively.

Since the start of QE4, mortgage spread performance has been bifurcated between production coupons buoyed by over $1 trillion in Fed purchases and “non-Fed” coupons exposed to primary rates at all-time lows.

Fed purchases remove the most negatively convex bonds and boost the carry profile of “to-be-announced” (TBA) securities, which has resulted in the outperformance of lower coupons versus the mortgage index. Given the small percentage of the index that lower coupons comprise and the Fed’s stated intention to continue with $40 billion of monthly net purchases, this is a trend we expect to continue. Primary rates remain near all-time lows at well below 3 percent despite the recent rates selloff, leading call-protected subsectors of the market, including specified pools and Agency CMBS, to enjoy some of their best relative performance in recent memory. Heading into 2021, we expect heightened prepay concerns to remain as mortgage originators increase capacity to meet demand and capitalize on record profitability.

Against this longer-term outlook, we favor investments where either the collateral or structure offers some cash flow stability. We find select subsectors—especially those not directly purchased by the Fed—attractively priced in the current environment, including off-the-run Agency CMBS, select specified pools, and locked-out collateralized mortgage obligation structures. These investments enjoyed strong performance prior to Fed intervention, and we expect similar results when the Fed eventually reduces the pace of its Agency MBS purchases and the market's focus returns to cash flow fundamentals.

—Aditya Agrawal, CFA, Director; Louis Pacilio, CFA, Vice President

Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

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. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management.

©2021, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.

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