May 24, 2016
While Agency MBS spreads have trended slightly wider over the quarter, they continue to hold within a narrow band. As rates rallied in the first quarter, 2014 and 2015 vintage borrowers saw their first opportunity to refinance. Quickening prepayment speeds and the approach of the home purchase season should increase supply, but spread widening should remain well-contained as domestic and international demand remains strong.
Agency MBS spreads to Treasurys have widened slightly but remained in a relatively narrow band during the first quarter of 2016. Demand from domestic and international buyers has helped offset any weakness related to greater supply and a pickup in prepayment speeds.
Source: Bloomberg, Guggenheim. Data as of 4.13.2016.
On the domestic front, the Fed remains the only participant that can offset declining government-sponsored enterprise (GSE) support for the housing market. This market demand cannot be replicated by private participants without dramatic asset repricing. The Fed will reinvest principal payments for the foreseeable future, thereby continuing to absorb approximately one third of all new originations. Internationally, the yield differentials provided by U.S. Agency MBS will likely spur foreign demand. Japan currently owns 18 percent of all non-domestically held Agency MBS securities, and the Bank of Japan’s new negative interest rate regime increases the possibility that it will purchase even more. In this low-yielding environment, Agency MBS is expected to provide increased incremental risk-adjusted returns relative to other fixedincome government-backed securities.
Agency MBS gained 2 percent on a total return basis in the first quarter of 2016 based on the subcomponent of the Barclays U.S. Aggregate index, with spreads to Treasurys widening to 107 basis points from 99 basis points. Spread widening is largely a reflection of benchmark rates declining more rapidly. Agency MBS yields have also declined by 0.42 percent over the quarter, from 2.77 percent to 2.35 percent.
At current pricing levels, we find 30-year current coupon loan balance pools provide the best risk-reward tradeoff in the Agency MBS market, offering relative prepay protection with minimal pay ups versus to-be-announced (TBA) pools. Agency MBS should also perform well in a curve-flattening scenario. Longer-term accounts can leverage their position using CMO structures, but will give up relative liquidity. The more liquid pass-through pools enable easier exit while minimizing bid-ask spread risk.
One of the consequences of the financial crisis was the placing of Fannie Mae and Freddie Mac (together, the governmentsponsored enterprises, or GSEs) into conservancy, which resulted in a significant restriction of their investment activity. The reduction in their market demand has been more than offset by the Fed’s own balance sheet expansion, which continues to offer strong support to the market.
Source: BofA Merrill Lynch Global Research. Data as of 9.30.2015.
—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Vice President
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.
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