Agency MBS: Historically Wide Spreads Signal Long-Term Value

This Agency Mortgage-Backed Securities sector report is excerpted from the Fourth Quarter 2022 Fixed-Income Sector Views.

Agency MBS spreads widened over the third quarter, driven by a hawkish Fed navigating an uncertain macroeconomic environment. Option-adjusted spreads ended the quarter at 69 basis points, 23 basis points wider than the prior quarter. The Bloomberg U.S. MBS Index third quarter total and excess returns were -5.35 percent and -1.69 percent, respectively. Notably, September’s returns were among the worst on record. Negative market conditions finally caught up with Agency commercial MBS, which had been relatively stable in the first half of the year. They posted third quarter total and excess returns of -4.64 percent and -0.62 percent, respectively.

Two factors have conspired to create the recent challenging market environment. First, the pace of the increase in benchmark interest rates over the third quarter exceeded that of the 2013 Taper Tantrum, with knock on effects for the pricing and hedging of MBS that are inherently sensitive to volatility. Second, changes in September to the Fed’s allowable monthly reinvestments in MBS, along with falling mortgage prepayment rates, put an end to Fed purchases of MBS. These fundamental and technical pressures resulted in periods of illiquidity and have driven spreads to levels not seen outside of the GFC.

We expect to continue to see significant short-term volatility in the Agency MBS markets, but we view the current backdrop as favorable for increasing allocations to Agency MBS as a long-term investment. With spreads at crisis levels, prices below par, declining origination, and limited convexity concerns, Agency MBS offers an attractive up-in-credit quality alternative to other intermediate investment-grade fixed-income assets. In addition to realizing higher income from historically high yields and spreads, an eventual normalization in interest rate volatility would further enhance total returns. In our view, discount-priced Agency RMBS passthroughs (where principal and interest payments flow to the MBS holder) are attractive because if rates reverse course and move lower, there is plenty of room for their discounted price to increase before rates reach a level where prepayment risk negatively impacts the bond price (a phenomenon called negative convexity). For similar reasons, we think low pay-up specified pools (where the pool of mortgages has more stable cash flows due to favorable loan characteristics), and locked-out collateralized mortgage obligation (CMO) structures (which offer structural protection from principal amortization for an initial period) also appear attractively priced because compared to more generic MBS alternatives their structures typically reduce prepayment risk and offer more price upside even at very low interest rate levels.

—By Aditya Agrawal and Louis Pacilio

Important Notices and Disclosures

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.

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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