Agency Mortgage-Backed Securities: New Year, New Market Dynamics
While short-term drivers for spread tightening are in place, we expect modest widening later in the year.
Agency MBS performance was positive in the fourth quarter, driven largely by carry as the quarter ended with higher rates and a flatter yield curve. Rangebound rates, low volatility, and reasonable valuations relative to credit sectors have resulted in stable Agency MBS spreads as investors continue to look for opportunities to add high-quality spread assets to their portfolios. Prepayments speeds were steady over the quarter. Agency MBS spreads have the potential to widen modestly from here as readings are tight compared to historical levels, and 2018 supply is expected to be higher than in recent years. However, we view this technical dynamic as disproportionately affecting Ginnie Mae (GNMA) MBS over Fannie Mae (FNMA). The GNMA share of outstanding Agency MBS has increased from approximately 10 percent to 30 percent over the last decade, as its share of net supply has been much higher. Strong demand for GNMA MBS from domestic banks and Japanese investors has resulted in GNMA MBS trading at tighter spreads or at higher prices than FNMA. However, demand from these sources is likely to be more muted going forward, even as demand from the Fed declines.
GNMA’s Share of the Agency MBS Market Has Tripled in the Past Decade
Share of Outstanding Agency MBS by Issuer
The GNMA share of outstanding Agency MBS has increased from approximately 10 percent to 30 percent over the last decade, as its share of net supply has been much higher. Strong demand for GNMA MBS from domestic banks and Japanese investors has resulted in GNMA MBS trading at tighter spreads or higher prices than FNMA.
Source: Bloomberg, Barclays, Guggenheim Investments. Data as of 12.31.2017.
The Bloomberg Barclays U.S. MBS index posted a 0.15 percent total return in the fourth quarter of 2017. Yields ended the quarter at 2.91 percent, higher than the previous quarter, while option-adjusted spreads were roughly 3 basis points wider over the quarter. Conventional MBS outperformed GNMA, 30-year MBS outperformed 15-year MBS, and lower coupons outperformed higher coupons.
We currently favor securities with less interest rate sensitivity—less negatively convex—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 bonds, new collateral types recently introduced by the government-sponsored enterprises, and some collateralized mortgage obligation structures. We continue to avoid assets, such as GNMA MBS, where valuations are relatively stretched and which may be more negatively affected by the Fed’s balance sheet runoff or a potential easing of the Basel Liquidity Coverage Ratio, which has motivated a portion of bank demand in recent years.
Agency MBS Spreads Widened Slightly in the Fourth Quarter
Bloomberg Barclays U.S. MBS Index Option-Adjusted Spread
The Bloomberg Barclays U.S. MBS index posted a 0.15 percent total return in the fourth quarter of 2017. Yields ended the quarter at 2.91 percent, higher than the previous quarter, while option-adjusted spreads were roughly 3 basis points wider over the quarter.
Source: Bloomberg, Barclays, Guggenheim Investments. Data as of 12.31.2017.
—Aditya Agrawal, CFA, Director; Louis Pacilio, Vice President
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