Agency Mortgage-Backed Securities: Overshadowed by Fed Policy
The Fed’s balance sheet normalization plans raise concerns, but declining prepayment risk should diminish the net impact.
The first glimpse into the Fed’s plan for balance sheet normalization came in the March 2017 FOMC minutes. Nothing official has been released, but we believe the Fed is attempting to set expectations that an announcement regarding the tapering of reinvestments will be delivered later this year. In fact, our Macroeconomic and Investment Research team believes this announcement could come with the September meeting. Investors are concerned about the impact this might have on Agency MBS spreads, but our view is that a full unwind of the Fed’s MBS portfolio would push Agency MBS spreads higher by 20–25 basis points from current levels over a prolonged period of time. This upward pressure is likely to be lessened by the declining incentive for borrowers to prepay their mortgages via refinancing activity (referred to as optionality). With only 10 percent of Agency MBS paying a weighted average coupon of more than 5 percent, a large share of mortgages in the Agency MBS market are not in the money to refinance. As this prepayment risk declines with rates going higher, the declining optionality should diminish the net impact from Fed balance sheet normalization.
Just 10% of Agency MBS Coupons Top 5%, Lowering Refinancing Risk
Volatile refinance-directed prepayments are very low, and as rates rise, the spread compensation for this risk will decrease even further. In this low refinancing environment, prepayment activity will primarily be guided by more stable home price appreciation.
Source: Freddie Mac, Fannie Mae, Federal Housing Administration, Mizuho, Guggenheim Investments. Data as of 4.4.2017.
The Agency MBS-U.S. Treasury basis has remained fairly stable as the market wrestles with shifting rate expectations. Agency MBS bonds posted a positive return of 0.5 percent in the first quarter of 2017. Yields ended the quarter at 2.9 percent, roughly unchanged from the end of 2016.
Our long-term view on the sector is that history has shown Agency MBS can deliver good risk-adjusted returns from a Sharpe and information ratio perspective. For those looking to Agency MBS for duration management, we prefer a combination of seasoned and cash flow story pass-through pools. In the near term, we believe there may be opportunities to pick up bonds at substantially wider spreads as the market adjusts to altering technical dynamics driven by Fed balance sheet expectations. In the event of continued rate increases, short-duration collateralized mortgage obligations (CMOs) will increasingly fill demand due to decreased production of traditional refinancing products such as 10- and 15-year pass-through pools. This will leave opportunities to pick up relative value in the remaining longer-end CMO structures.
Agency MBS Was a Top Risk-Adjusted Performer in Past Rate Hike Cycles
Over the past 20 years, there have been two complete cycles where the Fed raised rates. During both of these environments, the Agency MBS sector was a top performer from both a Sharpe and information ratio perspective.
Source: Barclays, Guggenheim Investments. Data as of 4.26.2017. The Sharpe ratio and the information ratio are standard calculations used in performance assessments: The Sharpe Ratio measures excess return per unit of standard deviation of returns, while the information ratio measures excess return versus a relevant benchmark index.
—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Director
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, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2017, 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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*Assets under management is as of 3.31.2019 and includes leverage of $11.3bn. 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. Securities offered through Guggenheim Funds Distributors, LLC, an affiliate of Guggenheim, SI, GFIA and GPIM.
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