Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, July 19, 2022
Fixed income markets have been hit hard this year by changing monetary expectations due to stubbornly high inflationary pressures. For investors allocated to a core bond strategy (as defined by the Bloomberg Aggregate index), returns have been the worst ever to start a year. And within these core bond sectors, there’s been no place to hide—even the traditionally defensive mortgage-backed securities (MBS) sector is down 8% this year (although the broader index is down nearly 10%). So what can investors expect going forward? While near term uncertainty is certainly high, we think the sector is in a good position to outperform.
Agency MBS performance is largely impacted by interest rate volatility as these securities are AAA-rated and government guaranteed. MBS have an embedded optionality with regard to the timing of principal and interest payments, so higher interest rate volatility equates to higher uncertainty around refinancing and mortgage prepayments. This is the primary fundamental risk for MBS. As seen on the LPL Chart of the Day, interest rate volatility, as defined by the MOVE index, has been near historically high levels and has seen a recent divergence from implied equity volatility (as defined by the VIX index). “MBS may have been disproportionally penalized given the rate volatility and uncertainty surrounding Federal Reserve (Fed) rate hikes,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “As interest rate volatility decreases, however, which we think will happen as the Fed gets through its rate hiking campaign, MBS may be poised to outperform.”
Another key risks for the MBS market in 2022 and 2023 is the potential for outright sales of securities by the Fed as it shrinks its balance sheet. Currently, the Fed is allowing securities to naturally roll off as they mature; however, the Fed has stated that it would like to aggressively shrink its balance sheet and primarily hold Treasury securities. However, given the maturity profile of the Fed’s MBS holdings and the repricing higher of mortgage rates recently, natural roll-off through prepayments seems unlikely at this point. As such, the Fed will likely be a seller of MBS in 2023, if not earlier. And while this would seemingly put upward pressure on yields and spreads, its likely we’ll see traditional MBS investors (mutual funds, banks, foreign investors) re-enter the market as they were crowded out due to Fed purchases. Moreover, the relative attractiveness of MBS versus high-grade corporates may improve to the point that investors may choose the AAA-rated paper with lower prepayment risks over the BBB-rated corporate paper that may experience elevated risks during an economic slowdown. That said, a continued weakening of the housing market could cause the Fed to reevaluate its plans to exit the MBS market completely. As such, we continue to think the risk/reward profile for owning MBS is attractive.
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