August 16, 2017
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.
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.
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.
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.
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.
—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Director
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