Former Problem Children, Agency Mortgage-Backed Securities, Make Case for Inclusion in Core Bond Portfolios

Any conversation about agency mortgage-backed securities drums up residual feelings of unease, given the rout of the investment vehicle during the financial crisis of 2008 and 2009. However, new insights out from Capital Group’s fixed income portfolio manager Pramod Atluri, suggests that great upside exists in agency MBS, as the offering looks more attractive because of where yields have landed.

During the COVID-19 pandemic, the Federal Reserve acquired more than $1 trillion of agency MBS to ease monetary policy and provide stability.

“This action in combination with others led yields to fall, mortgage durations to shrink, interest rate volatility to plummet and spreads to reach negative territory,” Atluri wrote. “By the end of 2022, all that had changed. The Fed’s hiking campaign and the fear that the central bank would offload MBS from its balance sheet led rates to rise, mortgage durations to extend, interest rate volatility to increase and spreads on agency MBS to reach some of the widest levels against Treasuries since the global financial crisis of 2008. In my view, each of the factors that led agency MBS to significantly underperform in 2022 are reasons to consider owning MBS in 2023.”

Citing a weaker housing market, in addition to slower growth and the tamping down of inflation, Alturi sees it as unlikely that the Fed will sell agency MBS into the market, and as this risk gets priced out, agency MBS valuations should rise. Furthermore, Alturi anticipates that interest rate volatility will steady, as a terminal interest rate is reached, benefiting agency MBS valuation further.

“Mortgage valuations have typically improved when interest rate volatility falls, because agency mortgage borrowers in the U.S. have an option to repay their loans early,” penned Alturi. “When rate volatility falls, the early payment option becomes less valuable to borrowers and the value accrues to mortgage investors.”

Comparing the opportunity in agency MBS against treasuries and other asset-backed sectors, Alturi wrote, “AAA-rated agency mortgage yields [begin] the year around 80 to 100 bps above Treasuries,” while highlighting that agency MBS duration profile is more attractive, given the current macroeconomic climate, than asset-backed offerings of credit card and auto loan syndications that exist.

Eaton Vance Investment Insights depict an environment not seen in the asset class since the early 2000s, not to invoke anxiety, but rather that sizable yields exist in the space for investors. “Higher-coupon agency MBS yields are now close to 6% for the first time since the early 2000s,” wrote Andrew Szczurowski, head of agency MBS and portfolio manager at the firm. “In our view, supply of agency MBS is set to fall significantly in 2023, as mortgage rates [at] 7% have dramatically slowed U.S. home sales and eliminated any cash-out refinance supply. Declining supply in 2023 should more than offset the absence of the Federal Reserve in the MBS market, providing a nice technical tailwind for MBS spreads.”

Alturi does not view CMBS as nearly as strong an opportunity as that presented by the residential equivalent: “I remain cautious on the fundamentals [of the commercial real estate space] and am not expecting to add in 2023. There is still an uncertain outlook post-COVID in terms of occupancy, and many properties are now refinancing at much higher rates.”

According to Federal Reserve data, national mortgage debt stood at $11.39 trillion at the end of June 2022, while at the end of 2022’s first quarter, the Federal Reserve recorded home equity value at $27.8 trillion. In data released on December 9, 2022, by Yardeni Research depicting Q3 projections, total household equity was $29.6 trillion, while mortgage debt was $12.4 trillion, providing a sizeable theoretical gap in equity for investors to feel secure in these securitized investment vehicles, which in the not-so-distant past were the scorn of the financial world.