Agency MBS Could Offer More Attractive Valuations Amid Resilient DemandJuly 24, 2018
- Although agency MBS have faced headwinds since the Federal Reserve began reducing its balance sheet reinvestment in October 2017, we now see some relative value in the sector amid resilient demand.
- Expectations for increased MBS issuance in 2018 also contributed to investor worries about weakening technical conditions, but issuance has been lower than expected so far, and other buyers have stepped in as the Fed has reduced its role.
- Yield spreads between agency MBS and credit sectors have widened from record lows in 2018 but still have not returned to longer-term historical averages, indicating that agency MBS could provide value relative to risk assets.
- Within the agency MBS sector, we believe shorter-duration MBS with higher coupons could offer the best relative value.
After recently generating weak returns relative to Treasuries, agency MBS now appear to offer more attractive valuations. The sector underperformed in May as political uncertainty in Europe led investors to seek out high-quality sovereign debt. More broadly, agency MBS have faced headwinds since the Federal Reserve began reducing its balance sheet reinvestment in October 2017. However, demand for MBS has been resilient, and fundamentals appear solid. Additionally, higher interest rates have reduced prepayment risk, which can reduce returns as homeowners refinance mortgages at lower rates.
BUYERS STEP IN AS FED WINDS DOWN BALANCE SHEET
Investors have been concerned about how MBS demand would hold up after the Fed started to reduce its support for the sector as part of its plan to slowly shrink its USD $4.5 trillion balance sheet, which was a legacy of its massive purchases of Treasury bonds and MBS in the aftermath of the 2008 financial crisis.
According to the plan that the central bank decided on last summer, the Fed is reinvesting only the amount that exceeds a monthly cap. This cap started at USD $4 billion for agency MBS and is increasing by USD $4 billion every three months until it reaches USD $20 billion. Reducing reinvestment at this pace will almost entirely remove the Fed as a buyer of agency MBS by the end of 2018.
In addition to the Fed’s efforts at balance sheet normalization, expectations for increased MBS issuance in 2018 contributed to investor worries about weakening technical conditions. However, issuance has been lower than expected so far, and other buyers have stepped in as the Fed has reduced its role. As yields have become more attractive, banks have been adding MBS to their balance sheets, and large asset managers have also been purchasing MBS at an increasing rate.
LIQUIDITY, SOLID FUNDAMENTALS ATTRACT DEMAND
There was uncertainty about the level of interest money managers would show for MBS this year, but we believe there are several factors that have made the sector appealing, including its liquidity. Concerns may also be growing about how higher-risk, less liquid fixed income segments will hold up as central banks reduce the quantitative easing (QE) programs they put in place after the global financial crisis.
In addition to holding interest rates at historically low levels to help stimulate economic activity, another goal of the Fed’s QE was pushing investors into riskier asset classes in search of yield, helping to keep credit flowing. This supported a lengthy rally in corporate credit that pushed credit spreads to near historically narrow levels. Yield spreads between agency MBS and credit sectors have widened from record lows in 2018 but still have not returned to longer-term historical averages, indicating that agency MBS could provide value relative to risk assets (Figure 1). Furthermore, MBS could hold up well on a relative basis if corporate bonds face headwinds from increasing merger activity and a subsequent spike in issuance to finance deals.
Source: Barclays Live.
*Zero-volatility spread levels adjusted for duration and 120-day trailing spread volatility. Based on current-coupon 30-year Fannie Mae MBS and Bloomberg Barclays U.S. Investment-Grade Corporate Index spreads.
Fundamentals in the mortgage-backed sector also appear strong. Against a backdrop of near record-low unemployment and slowly rising wages that has bolstered consumer strength, the housing market appears to be on a solid foundation as demand for houses is exceeding supply.
We believe the biggest near-term risk for the sector would be if the Fed were to take a more aggressive approach to tightening monetary policy than the market currently expects. A faster pace of rate hikes, tighter financial conditions, and increased rate volatility could hurt the MBS market.
SHORTER-DURATION AGENCY MBS AND GNMAS APPEAR ATTRACTIVE
Within the sector, we generally see less value in longer-term bonds as a result of the flattening yield curve. We believe shorter-duration MBS with higher coupons could offer the best relative value. The higher yields these securities offer can provide some cushion against the possibility of short-term volatility.
Besides agency MBS, which are issued by Fannie Mae and Freddie Mac, we are also seeing more attractive relative values in Ginnie Mae (GNMA) MBS. GNMAs faced headwinds in 2017 amid reports that some lenders participating in a Department of Veterans Affairs loan program had been “churning” borrowers, or lending at a rate they knew could be refinanced lower within a short time to capture more commissions. This activity artificially elevated prepayments and weighed on the segment. However, we have become more constructive on these securities following federal investigations of these practices, and the recent passage of revisions to the Dodd-Frank law provides consumer protections that should help slow prepayments.
June 30, 2008–June 30, 2018
Sources: High Yield Corporate—J.P. Morgan Global High Yield Index, EM Debt Dollar—J.P. Morgan Emerging Markets Bond Index Global, U.S. Corporate Investment Grade—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index.*
Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission.
Yield spreads over Treasuries are the calculated spreads between a computed option-adjusted spread index of all bonds in a given rating category and a spot Treasury curve.
*Option-adjusted spread for the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index as of June 30, 2018. Spread-to-worst for the J.P. Morgan Global High Yield Index as of June 30, 2018.
(As of June 30, 2018)**
Past performance is not a reliable indicator of future performance.
Sources: T. Rowe Price, Bloomberg Barclays, J.P. Morgan, and S&P/LSTA.
**U.S. Treasuries—Bloomberg Barclays U.S. Treasury Index, U.S. TIPS—Bloomberg Barclays U.S. TIPS Index, Global Sovereign ex-U.S.—Bloomberg Barclays Global Aggregate ex-U.S. Index, U.S. Municipals—Bloomberg Barclays Municipal Bond Index, MBS—Bloomberg Barclays U.S. MBS Index, CMBS—Bloomberg Barclays U.S. CMBS Index: ERISA Eligible, ABS—Bloomberg Barclays Asset Backed Index, Global Investment-Grade Corporate—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index, Global High Yield Corporate—J.P. Morgan Global High Yield Index, Bank Loans—S&P/LSTA Performing Loans Index, EM Dollar Sovereigns—J.P. Morgan Emerging Markets Bond Index Global, EM Corporates—J.P. Morgan CEMBI Broad Diversified, EM Local—J.P. Morgan Global Bond Index–Emerging Market Global Diversified.
†European corporates are included in this sector.
Key Risks—The following risks are materially relevant to the strategies highlighted in this material: Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates, which may affect the value of an investment. Returns can be more volatile than other more developed markets due to changes in market, political, and economic conditions. Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default, which may affect the value of an investment. Investments in high yield securities involve a higher element of risk. Companies issuing leveraged loans typically have a below investment-grade credit rating, and the loans could have greater price declines than higher-rated bonds.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of July 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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