The Agency MBS market has many short-term crosscurrents to contend with, but there are reasons to be positive longer term and our strategies have broadly increased their exposure to the sector given attractive valuations. In the short term, volatility headwinds abound. Market consensus for terminal fed funds rate was thrown into question in the first quarter due to persistent inflation and strong employment data. This uncertainty weighed on mortgages with the Bloomberg U.S. MBS Index posting total and excess returns of 2.53 percent and -0.50 percent, respectively, in the first quarter. The banking sector turmoil helped put a lid on terminal rates but then introduced the headwind of portfolio sales, which has driven mortgage spreads to nominal levels only seen a handful of times in the last decade.
With regard to the FDIC portfolio sale, we expect passthrough sales to go smoothly due to the large, structural underweight of index-tracking funds. As these sales will come in deep discount coupons, we prefer MBS exposure via production coupon passthroughs (new securities based on the current mortgage rate) that are not directly impacted. In contrast, we remain cautious on the collateralized mortgage obligations and Agency CMBS subsectors due to both the lack of natural index-tracking buyers for FDIC portfolio bonds and limited dealer capacity to warehouse risk of this magnitude.
We also see a headwind in the structural shift in the buyer base of the mortgage market. This year will mark the first time in over a decade that neither the Fed nor banks are actively buying. While this is undoubtedly a negative, current spread levels and the Agency-backed nature of the sector should be enticing to crossover buyers from the corporate debt space. This is especially true for investors like us who are concerned about the mounting risk of recession. Our long-run bull case for mortgage spreads revolves around a normalization of interest rate volatility. We believe that clarity around the Fed’s terminal rate will be the biggest driver of a reduction in rate volatility. As this becomes clear to the market, it will favor production coupon passthrough securities that are priced at par and have higher option costs embedded in their high current yields.
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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 3.31.2023 and includes leverage of $14.7bn. 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 Advisors, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC.
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