Agency Mortgage-Backed Securities: The Fed Has Spoken, Now It Is the Market's Turn

The Fed’s tapering program may pressure Agency MBS, but it could also increase investment opportunities.

November 14, 2017


This Agency Mortgage-Backed Securities sector report is excerpted from the Fourth Quarter 2017 Fixed-Income Outlook.

Agency MBS performance was positive in the third quarter, driven largely by tighter spreads and carry as the quarter ended with marginally higher rates and a flatter yield curve. Range-bound rates, low volatility, and reasonable valuations relative to other credit sectors have resulted in tighter Agency MBS spreads as investors continue to look for opportunities to add high-quality assets to their portfolios. Prepayments speeds were steady over the quarter. Fed policy has been well-telegraphed and the market has digested it so far, but Agency MBS spreads have the potential to widen from here as levels are historically tight and supply is expected to increase as Fed holdings decline. Conversely, a flattening yield curve could improve duration-hedged carry for Agency MBS. This attractive carry could dampen the impact of any spread widening. Relative-value opportunities will also likely increase in Agency MBS as the Fed withdraws from the market and its influence on valuations decreases. We are watching factors that have been supportive of Agency MBS so far—especially the benign prepayment environment, mortgage real estate investment trusts with price/book ratios above 1.0, bond fund inflows, robust bank demand, repo availability, and fair valuations compared to credit sectors—to spot signals for a change in the current market environment. In short, the nightmare scenario of dramatic spread widening with reduction of the Fed’s balance sheet holdings is not likely to materialize in the short run.

Refi Incentives No Longer Carry the Same Prepayment Risk for Agency MBS

Relative-value opportunities will likely increase in Agency MBS as the Fed withdraws from the market and its influence on valuations decreases. We are watching factors that have been supportive of MBS so far—especially the benign prepayment environment.

Refi Incentives No Longer Carry the Same Prepayment Risk for Agency MBS

Source: JP Morgan, Goldman Sachs, eMBS, Guggenheim Investments. Data as of 9.29.2017. CPR = conditional prepayment rate.

The Bloomberg Barclays U.S. MBS index posted a 1.0 percent total return and 0.5 percent excess return over Treasurys with similar durations in the third quarter. Yields ended the quarter at 2.8 percent, lower from the previous quarter, while spreads were roughly 10 basis points tighter over the quarter. Conventional MBS outperformed Ginnie Mae MBS, 30-year MBS outperformed 15-year MBS, and lower coupons outperformed higher coupons.

We currently favor less negatively convex assets 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, new collateral types recently introduced by the government-sponsored enterprises, and some collateralized mortgage obligation structures. We continue to avoid asset classes, such as Ginnie Mae MBS, where valuations are relatively stretched and may be affected more by the Fed’s policies or change in regulatory regime.

MBS Spreads Tighten in the Third Quarter, Despite Fed Runoff Announcement

The Bloomberg Barclays U.S. MBS index posted a 1.0 percent total return and 0.5 percent excess return to like-duration Treasurys in the third quarter of 2017. Yields ended the quarter at 2.8 percent, lower from the previous quarter, while spreads were roughly 10 basis points tighter over the quarter.

MBS Spreads Tighten in the Third Quarter, Despite Fed Runoff Announcement

Source: Bloomberg, Guggenheim Investments. Data as of 9.29.2017.

—Connie Fischer, Senior 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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