Trick or Treat for Mortgage-Backed Securities?

Mortgage-backed securities (MBS) have experienced a tumultuous journey over the past few years. After serving as a direct beneficiary of the quantitative easing programs and regulatory regime since the Great Financial Crisis (GFC), MBS bore the brunt of the historic tightening by the Fed in 2022-2023, both in the form of rate hikes and quantitative tightening. Now that the Fed is largely done with rate hikes and MBS valuations are at their cheapest in years, we believe the risk/reward for MBS is solid, especially over longer time horizons.

MBS are financial instruments that have a claim on the cash flows generated by a pool of mortgages. They are typically issued through government sponsored entities (GSEs) such as Fannie Mae (FNMA) and Freddie Mac (FHLMC). And while Fannie and Freddie are technically independent companies, they have a unique relationship to the US government in that there is an implicit guarantee that the US would support the bonds in times of crisis, which has been the case in the QE programs post-GFC and Covid. Because of this dynamic, investors and credit ratings agencies regard agency MBS as having little to no credit risk with a AAA rating.

Recent interest rate volatility, however, has caused disruptions to the expected cash flows of MBS, leading to an outsized effect on valuations. The rapid and persistent increase in inflation in 2022, along with the Fed’s aggressive response caused a period of lofty interest rate volatility, resulting in the worst performance of MBS since the GFC. The chart below shows our preferred measure of MBS spread, the current-coupon MBS spread versus treasuries, versus the level of interest rate volatility. Spreads on MBS are now at the widest level in 15 years, wider than any point during Covid.

Indeed, the spread now rivals that offered by corporate bonds. The spread over treasuries of current coupon MBS, a AAA-rated asset, is now above the spread of BBB corporate bonds, which we believe offers tremendous value on a standalone basis, as well as in a multi-sector portfolio as a diversifier to corporate bonds.

Going forward, bank demand will be key as the banking sector had been a big buyer of MBS for the past 15 years until the recent stress in US regional banks. The increase in treasury issuance along with Fed QT continue to weigh on the banking sector; however, much of move in rates has already taken place after the historic bond selloff that started in July.

We believe the risk/reward outlook for MBS is favorable. The end of the rate hiking cycle and slowing inflation should result in a calmer period for interest rates. Additionally, fears of an economic slowdown due to rising interest rates, dwindling household savings, and geopolitical uncertainty are likely to increase flows into MBS as investors seek a “defensive spread.”

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at?www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.