Agency Mortgage-Backed Securities: The Fed Has Spoken, Now It Is the Market's Turn
The Fed’s tapering program may pressure Agency MBS, but it could also increase investment opportunities.
Agency MBS performance was positive in the third quarter, driven largely by tighter spreads and carry as the quarter ended with marginally higher rates and a flatter yield curve. Range-bound rates, low volatility, and reasonable valuations relative to other credit sectors have resulted in tighter Agency MBS spreads as investors continue to look for opportunities to add high-quality assets to their portfolios. Prepayments speeds were steady over the quarter. Fed policy has been well-telegraphed and the market has digested it so far, but Agency MBS spreads have the potential to widen from here as levels are historically tight and supply is expected to increase as Fed holdings decline. Conversely, a flattening yield curve could improve duration-hedged carry for Agency MBS. This attractive carry could dampen the impact of any spread widening. Relative-value opportunities will also likely increase in Agency MBS as the Fed withdraws from the market and its influence on valuations decreases. We are watching factors that have been supportive of Agency MBS so far—especially the benign prepayment environment, mortgage real estate investment trusts with price/book ratios above 1.0, bond fund inflows, robust bank demand, repo availability, and fair valuations compared to credit sectors—to spot signals for a change in the current market environment. In short, the nightmare scenario of dramatic spread widening with reduction of the Fed’s balance sheet holdings is not likely to materialize in the short run.
Refi Incentives No Longer Carry the Same Prepayment Risk for Agency MBS
Relative-value opportunities will likely increase in Agency MBS as the Fed withdraws from the market and its influence on valuations decreases. We are watching factors that have been supportive of MBS so far—especially the benign prepayment environment.
Source: JP Morgan, Goldman Sachs, eMBS, Guggenheim Investments. Data as of 9.29.2017. CPR = conditional prepayment rate.
The Bloomberg Barclays U.S. MBS index posted a 1.0 percent total return and 0.5 percent excess return over Treasurys with similar durations in the third quarter. Yields ended the quarter at 2.8 percent, lower from the previous quarter, while spreads were roughly 10 basis points tighter over the quarter. Conventional MBS outperformed Ginnie Mae MBS, 30-year MBS outperformed 15-year MBS, and lower coupons outperformed higher coupons.
We currently favor less negatively convex assets where either the collateral or structure offers some cash flow stability. Accordingly, we find select subsectors attractively priced in the current environment, including longer-maturity Agency multifamily, new collateral types recently introduced by the government-sponsored enterprises, and some collateralized mortgage obligation structures. We continue to avoid asset classes, such as Ginnie Mae MBS, where valuations are relatively stretched and may be affected more by the Fed’s policies or change in regulatory regime.
MBS Spreads Tighten in the Third Quarter, Despite Fed Runoff Announcement
The Bloomberg Barclays U.S. MBS index posted a 1.0 percent total return and 0.5 percent excess return to like-duration Treasurys in the third quarter of 2017. Yields ended the quarter at 2.8 percent, lower from the previous quarter, while spreads were roughly 10 basis points tighter over the quarter.
Source: Bloomberg, Guggenheim Investments. Data as of 9.29.2017.
—Connie Fischer, Senior Managing Director; Aditya Agrawal, CFA, Director
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