Phiwath Jittamas
By Jason W. Smith
In a post-QE4 higher-mortgage-rate environment, we think construction of an Agency MBS allocation should focus on two major themes.
In the aftermath of the large Federal Reserve bond-buying program and low interest rates of QE4, and the subsequent realignment to much higher nominal interest rates with monetary policy shifting to fight inflation, the Agency Mortgage-Backed Securities market finds itself with two prominent opportunities to capture value.
The first opportunity is a more traditional one – buying current-coupon MBS. These are the bonds that are currently being originated at close to par price and have coupons that range in the 5.0% to 6% range. As we have highlighted in the past, during QE4, the Fed was the marginal buyer of current-coupon MBS, pushing spreads to very tight levels and crowding out private investors. With the removal of the Fed as the main buyer and the elevated rate volatility of 2022, spreads have widened out to historically attractive levels for this class of bonds. In a lower-rate volatility environment, we believe these bonds should provide investors with very attractive carry in the near term.
The second opportunity is one that the Agency MBS market has traditionally not had to deal with. It is the fact that almost all of the sector’s outstanding bonds trade at a meaningful discount price. (The current MBS Index price is approximately $90 compared to a historical average of $103.) What this does is completely change the impact of prepayments (which are the primary cash flow risk to the bond and are mostly driven by mortgage refinancings). At a premium dollar price, early prepayments are negative and erode your carry. In contrast, prepayments on a discount-priced bond are a positive impact as you get paid back at par immediately. This is not to say that we anticipate fast prepayments on out-of-the money Agency MBS bonds that have low coupons and low mortgage rates. The lock-in effect of these rates is real and is likely to suppress overall prepayment activity at a low level for a while. With that in mind, given the deep discount price of these bonds, an investor can buy them knowing their downside yield with a high degree of confidence and enjoy meaningful upside if prepayment activity is even marginally higher than what is priced in.
To conclude, for fixed income investors looking to allocate to Agency MBS in 2023, a portfolio that includes a combination of current-coupon MBS and a basket of discount-priced MBS could provide high-quality carry with upside potential.
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