We believe there are two primary reasons that help explain why the return on agency mortgage-backed securities (MBS) lagged in 2022. First, the supply-and-demand dynamic in agency MBS shifted dramatically as the U.S. Federal Reserve (Fed) swung from a major buyer to a source of supply. Second, significantly higher interest-rate volatility put pressure on valuations due to the optionality embedded within MBS securities.
Facing swirling headwinds
Agency MBS are widely considered to be high-quality securities, backed by the full faith and credit of the U.S. government. However, agency MBS do entail a degree of credit risk and, like other credit-sensitive fixed-income sectors, agency MBS will typically experience spread widening during risk-off periods, although often to a lesser degree. Reviewing the performance in previous market environments stretching back to 2000, corporate credit spreads typically widened two to four times more than agency MBS spreads. In this cycle, however, agency MBS experienced more pronounced widening relative to other spread sectors, reaching levels that suggest the segment could be attractive on a relative value basis. Notably, agency MBS spreads are currently trading wider than intermediate corporates, a rare occurrence.
MBS spreads have widened significantly in this cycle
Credit spreads by sector (bps)
Source: J.P. Morgan, as of 9/11/23. Intermediate corporates are represented by the J.P. Morgan U.S. Liquid Index (JULI), which tracks the performance of a specific corporate bond or sector against the subset of the most liquid bonds in the investment-grade market. It is not possible to invest directly in an index. bps refers to basis points. MBS refers to mortgage-backed securities. CMBS refers to commercial MBS. ABS refers to asset-backed securities.
We believe the shift in Fed policy was one of the biggest drivers of this uncharacteristic spread widening this year. After acting as one of the largest buyers of MBS during and immediately after the COVID-19 panic, the Fed began the process of balance sheet normalization (i.e., tapering) in the second quarter of 2022. Unsurprisingly, spreads widened as markets priced in this shifting supply-and-demand dynamic. Although the Fed doesn’t appear poised to begin selling off agency MBS outright, that possibility was almost certainly a driver of downward pressure on valuation.
Why rising rates put pressure on MBS
The historic interest-rate volatility plaguing fixed-income markets put additional pressure on MBS valuations, as the Fed acted aggressively to hike interest rates to combat soaring inflation. Interest-rate risk is the primary risk factor underlying MBS due to the prepayment optionality of the underlying collateral. When interest-rate volatility increases, the cost of the optionality embedded in the collateral increases as well. Further, as interest rates rise, homeowners become less likely to prepay or refinance the mortgages that are underlying these MBS, as they’re likely to already have a more preferable mortgage rate. This has the effect of increasing the duration (or interest-rate sensitivity) of the security as the pace of principal payments slows, extending the maturity of the MBS securities. Investors, in turn, will demand wider spreads to compensate for this increased risk, putting downward pressure on MBS valuations. As interest rates rapidly moved higher this year, pressure on valuations for agency MBS intensified due to this effect, helping to further explain the uncharacteristic spread widening experienced by this asset class over the past year.
Uneven impact from Fed balance sheet action
Expectations for a reduction of the Fed balance sheet, and particularly the potential for direct selling of its MBS holdings, weighed on the sector in 2022. Although the Fed has distanced itself from its earlier guidance around reducing MBS, any MBS selling program implemented by the Fed is unlikely to have the same impact on all areas of the agency MBS market. The Fed’s purchasing program took place during an extended period of low interest rates, which has resulted in a balance sheet heavily concentrated in lower-coupon MBS. For context, over 71.0% of the Fed’s portfolio is in 2.5% coupon MBS or lower, and it owns nearly half of the 2.0% coupon MBS market.
Fed MBS ownership concentrated in lower coupons
Fed MBS ownership by coupon (30 year)
Source: Federal Reserve Bank of New York, J.P. Morgan, as of 8/31/23. Fed refers to the U.S. Federal Reserve. MBS refers to mortgage-backed securities.
Should the Fed begin selling agency MBS holdings, we expect that the lower-coupon securities would feel the brunt of the additional supply with higher-coupon securities remaining relatively insulated. Prepayment speeds for lower-coupon securities slowed dramatically in 2022 as higher mortgage rates provided little incentive for borrowers to refinance or prepay their mortgages. This dynamic makes lower-coupon securities trade more like bulleted high-quality corporates. The current valuation and spread differential between lower-coupon MBS and high-quality corporates also support the expectation that this lower-yielding area of the market could experience further pressure should the Fed begin to actively sell MBS.
With volatility comes select opportunity
Although a range of factors have been negatively affecting agency MBS since early 2022, we believe there are ample opportunities for active managers to take advantage of the attractive yields within the sector.
Managers that are able to tilt portfolios toward higher-coupon mortgage pools may benefit from higher relative yields while also being potentially better insulated from any supply pressure. A focus on specified pools could provide additional protection in a volatile rate environment, as certain mortgage pools can contain loan attributes that are able to either insulate from prepayment risk if rates fall or extension risk if rates move higher. In addition, we believe that this increase in agency MBS yields provides an opportunity to shore up fixed-income portfolios in advance of a market downturn without sacrificing income, an important consideration in today’s late-cycle environment.
Looking ahead, we expect the uncertainty around the Fed’s monetary policy and heightened interest-rate volatility will likely continue to weigh on the sector, but we also believe that these risks can be navigated by active managers with the skill set and insight to adapt to the shifting dynamics driving the MBS market.
This material is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise. John Hancock Investment Management and our representatives and affiliates may receive compensation derived from the sale of and/or from any investment made in our products and services.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
Duration measures the sensitivity of the price of bonds to a change in interest rates.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Currency transactions are affected by fluctuations in exchange rates, which may adversely affect the U.S. dollar value of a fund’s investments. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions.
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