Agency Mortgage-Backed Securities: All Eyes on the Fed

Fed policy—and the market’s reaction to it—will be a key driver of opportunities in 2018.

August 16, 2017


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

Agency MBS performance was positive in the second quarter, driven by a continued softening in volatility and lower net supply relative to expectations. Additionally, tight spreads in credit sensitive areas have helped make Agency MBS’s nominally tight spreads appear relatively attractive. These factors all contributed to spreads holding at relatively tight levels even as the Fed announced details about its portfolio runoff plans.

Agency MBS Spreads Trend Down Despite Looming Fed Tapering

TIght spreads in credit sensitive areas have helped make Agency MBS’s nominally tight spreads appear relatively attractive. Relative value considerations helped limit MBS spread widening even as the Fed announced its tapering plans.

Agency MBS Spreads Trend Down Despite Looming Fed Tapering

Source: Bloomberg, Guggenheim Investments. Data as of 7.4.2017.

The Fed plans a graduated quarterly schedule of runoff caps ending at $20 billion per month, most likely commencing in October. The Fed seems to understand its place as the most important source of demand for Agency MBS, particularly as Fannie Mae and Freddie Mac have shrunk their balance sheets.

Agency MBS Market Dynamics Will Shift with Fed Policy

The Fed seems to understand its place as the most important consistent source of post-crisis Agency MBS demand, particularly as Fannie Mae and Freddie Mac have shrunk their balance sheets. Increased supply concerns should not become a fundamental issue until 2018, when the Fed’s lower reinvestment levels become meaningful.

Agency MBS Market Dynamics Will Shift with Fed Policy

Source: BofA Merrill Lynch Global Research, Guggenheim Investments. Data as of Q1 2017.

If investors become concerned about tapering-induced supply, the basis could witness periods of pressure causing spreads to widen, but assuming tapering begins this year, increased supply concerns should not become a fundamental issue until 2018, when the Fed’s lower reinvestment levels become meaningful. At that point, we would expect foreign investors, domestic banks, and money managers to provide the backstop bid for Agency MBS, albeit at wider spread levels. Risks to this outcome include regulatory uncertainty, the relative value of competing products, and a potential increase in volatility. The path may not be smooth, but spreads will likely settle in approximately 20 basis points wider relative to current levels.

The Bloomberg Barclays U.S. MBS index posted a 0.9 percent return in the second quarter of 2017, the strongest since the second quarter of 2016. Yields ended the quarter at 2.9 percent, unchanged from the previous quarter, while the Agency MBS basis is roughly 10 basis points tighter since the beginning of the year.

There may be opportunities to pick up assets at substantially wider spreads as the market adjusts to the evolving technical dynamics driven by tapering expectations. We continue to prefer a portfolio of cash-flow story bonds for duration management. In particular, repayment risk is being driven by turnover as borrower-refinancing opportunities dwindle. Moreover, credit curing, marginally loosening lending standards, and home price appreciation are the turnover themes driving prepayments. Bonds exposed to these factors can provide opportunities to pick up relative value within the Agency MBS sector.

The Fed plans a graduated quarterly schedule of runoff caps ending at $20 billion per month, most likely commencing in October. The Fed seems to understand its place as the most important source of demand for Agency MBS, particularly as Fannie Mae and Freddie Mac have shrunk their balance sheets.

If investors become concerned about tapering-induced supply, the basis could witness periods of pressure causing spreads to widen, but assuming tapering begins this year, increased supply concerns should not become a fundamental issue until 2018, when the Fed’s lower reinvestment levels become meaningful. At that point, we would expect foreign investors, domestic banks, and money managers to provide the backstop bid for Agency MBS, albeit at wider spread levels. Risks to this outcome include regulatory uncertainty, the relative value of competing products, and a potential increase in volatility. The path may not be smooth, but spreads will likely settle in approximately 20 basis points wider relative to current levels.

The Bloomberg Barclays U.S. MBS index posted a 0.9 percent return in the second quarter of 2017, the strongest since the second quarter of 2016. Yields ended the quarter at 2.9 percent, unchanged from the previous quarter, while the Agency MBS basis is roughly 10 basis points tighter since the beginning of the year.

There may be opportunities to pick up assets at substantially wider spreads as the market adjusts to the evolving technical dynamics driven by tapering expectations. We continue to prefer a portfolio of cash-flow story bonds for duration management. In particular, repayment risk is being driven by turnover as borrower-refinancing opportunities dwindle. Moreover, credit curing, marginally loosening lending standards, and home price appreciation are the turnover themes driving prepayments. Bonds exposed to these factors can provide opportunities to pick up relative value within the Agency MBS sector.

—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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