Gaining from the Flight to Quality

Agency MBS offers an opportunity to diversify volatility and liquidity risk as we near the end of the credit cycle.

March 17, 2016

This sector report is excerpted from the First Quarter 2016 Fixed-Income Outlook.

As one of the most liquid fixed-income markets in the world ($5.8 trillion outstanding), Agency MBS is a high-quality asset class that, with higher yields than Treasurys, typically sees inflows during periods of high volatility. Investor concerns are currently focused on the timing of the Fed’s winding down of its $1.75 trillion Agency MBS portfolio, but recent market volatility suggests that the Fed will be in no hurry to reduce the size of its balance sheet. As such, we believe Agency MBS represents an opportunity to diversify volatility and liquidity risk as we near the end of the credit cycle.

Fed Reinvestments Provide Steady Demand Through Turbulent Times

Many investors are worried over the negative repercussions of fewer MBS purchases by the Fed. However, the Fed is expected to continue reinvesting proceeds of its portfolio for at least the first year of a Fed hiking cycle. The Fed’s steady demand, coupled with the sector’s flight-to-safety characteristic, makes it an attractive option for diversifying a portfolio to withstand periods of volatility.

Fed Reinvestments Provide Steady Demand Through Turbulent Times

Source: JP Morgan, Nomura, Guggenheim Investments. Data as of 1.31.2016.

Buoyed by a flight to quality in 2015, U.S. Agency MBS gained 1.5 percent on a total return basis based on the subcomponent of the Barclays U.S. Aggregate Index, with spreads to Treasurys tightening by approximately 8 basis points. The Fed was a major participant in the Agency MBS market in 2015, purchasing 27 percent of monthly origination volume on average, a meaningful market share that we expect will continue for at least the first year of the tightening cycle. Some attribute positive 2015 performance to Fed purchases, but we believe that the Fed’s participation amplifies, rather than defines, the Agency MBS market’s role as a pillar of stability in turbulent markets. Agency MBS also benefitted from foreign demand and domestic banks seeking their liquidity and capital-treatment characteristics.

The main risk in our sector is faster-than-expected prepayments. In 2015, 10-year Treasury yields rose by 63 basis points, causing prepayment speeds to fall across Fannie Mae, Freddie Mac, and Ginnie Mae collateral. Barring a sustained rally that would cause yields to tumble, we do not foresee the pace of prepayments increasing. With prepayment risk well-contained for the majority of collateral, we find value in bonds that would perform well in an environment in which the yield curve goes up or down 50 basis points from the time of purchase, and bonds that continue to benefit from regional home price appreciation and improving credit quality among the underlying borrowers.

Prepayment Speeds Remain Contained in Stable Rate Environment

Mortgage prepayments typically decline as market yields rise. With 10-year U.S. Treasury yields rising by 63 basis points in 2015, prepayment speeds fell across Fannie Mae, Freddie Mac, and Ginnie Mae collateral. We believe prepayment risks remain well-contained for the majority of collateral.

Prepayment Speeds Remain Contained in Stable Rate Environment

Source: eMBS, Bloomberg, Guggenheim. Data as of 12.31.2015.

—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Vice President

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, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.


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