Mortgage-backed securities (MBS) have cheapened considerably as interest rate volatility has remained high amid uncertainty on monetary policy. With spreads hovering above historical averages, we believe residential agency MBS provides the potential for attractive risk-adjusted returns in core and core plus portfolios. Even after some tightening in May, the Bloomberg U.S. MBS Index’s option-adjusted spread (OAS) ended the second quarter 17 basis points (bps) above its 10-year average at 51 basis points.

1. A decline in rate volatility should benefit mortgage securities

Interest rate volatility has been elevated as markets have tried to adjust for potential Federal Reserve policy moves amid softening inflation, a strong job market and a robust consumer. Nevertheless, with the Fed having raised rates by 500 basis points over the last 16 months, we believe the central bank is closer to the end of its hiking cycle, even if it does not start reversing policy by cutting rates anytime soon.

Monetary policy works with a lag and we expect tighter financial conditions o have an impact on the economy, even if we do not enter a deep recession. As the Fed pulls back, we expect rate volatility to decline. Mortgage-backed securities tend to track rate volatility because of the housing market’s sensitivity to rates and the securities’ embedded prepayment option. (Bonds essentially get called away if the homeowner prepays the mortgage.)

2. Supply-demand dynamics have improved

A large portion of MBS assets seized by the Federal Deposit Insurance Corp. (FDIC) following the collapse of some regional banks were successfully sold during the second quarter. Spreads widened on the back of supply hitting the market, but the orderly process quelled concerns about potential market disruption.

The Federal Reserve has been a net seller as it shifts from quantitative easing to quantitative tightening, reducing its holdings of mortgage securities and other financial assets on its balance sheet. Overall, the Fed and FDIC’s actions have unlocked a lot more tradable float, which in some ways counter-intuitively, is helping to normalize this market.

Our banking analysts do not expect another avalanche of supply from regional banks – even if the economic situation gets markedly worse and we start to see more failures. Looking further out, if there are regulatory changes impacting how banks account for risk in their investment portfolios, it will probably make it harder for them to buy agency mortgage assets, especially the longer duration securities. That could create some longer term structural changes in demand, which could also be an opportunity for money managers and relative value investors like us to step in as banks and the Fed step back.

3. Current coupon securities provide attractive carry

Nominal spreads on current coupon mortgages in the Bloomberg U.S. Mortgage Backed Securities Index, (securities created from the most recently originated loans and hence carrying coupons close to prevailing interest rates) trade at a spread of about 140 basis points above Treasuries, compared to a spread of around 130 basis points in aggregate for investment-grade (BBB/Baa and above) corporate bonds.

Mortgage investors more commonly look at metrics like option-adjusted spreads (OAS), which account for the bonds’ callability and the potential impact of interest rate volatility, rather than nominal spreads. And while it is true such adjusted metrics do not look especially cheap at present, we believe rate volatility is likely to be lower than what's currently priced in the market.

If we are right, it means current coupon MBS could provide returns that are close to the current nominal spread. At these levels, given the limited credit risk (due to the implicit or explicit backing of the U.S government on agency MBS), we believe the gap between OAS and nominal spreads provides adequate compensation for the downside risk.

Current coupon securities also provide a higher coupon and yield relative to older vintage mortgage securities, which were issued when rates were much lower. A large part of the Bloomberg U.S. Mortgage Backed Securities Index consists of these lower coupon (2% - 3%) bonds which do not currently offer very compelling carry (interest income). But these bonds are also typically trading well below par. This can help insulate investors from outsized downside risk. With average mortgage rates in the U.S. around 7%, their prepayment risk is low and the negative convexity we usually see in this market should remain limited.

4. MBS will likely hold up better in a risk-off market

At this late stage of the economic cycle, the full impact of monetary tightening is still yet to play out. While the economy is showing resilience, we believe it is premature to conclude that we are out of the woods.

In such an environment, we believe that mortgage-backed securities that provide a high level of carry and spread, are likely to hold up better than investment-grade corporate bonds given the correlation of credit to equities and other risk assets in a risk-off environment.

The fragility of the regional banks remains a potential weak link in the system. And should another bout of stress ripple through the banking system, it will likely lead the Fed to lower policy rates.

In a risk-off environment, the Fed has shown itself to be supportive of financial markets through its quantitative easing program in addition to cutting rates. Mortgages sit within what we refer to as the “circle of trust.” There could be situations in which the Fed is not willing to support the corporate bond market or equity market, but they have shown support for the agency mortgage market.

5. Pairing mortgages with a yield curve steepener

An inverted yield curve cannot last forever. Sooner or later, the Fed will start to lower interest rates as inflation cools and the job market softens. When the Fed lower rates, the yield curve typically steepens, which leads to a widening of mortgage spreads given their negative convexity.

Yield steepener positions have been largely unsuccessful this year, but we remain comfortable with their long-term potential. Despite bank stress and tighter financial conditions, the U.S. economy has stayed resilient, boosted by tight labor markets and strong consumer demand. However, growth and labor trends are softening, with leading indicators suggesting further weakness to come.

Therefore, in our view, pairing mortgage investments with a yield curve steepener position is a risk diversifier in portfolios. A yield curve steepener position favors shorter duration Treasuries over longer duration Treasuries and is designed to profit in an environment where the Fed would need to cut rates.

When the yield curve steepens, mortgages typically selloff due to concerns over prepayment risk. However, this environment may be different since the bulk of the Bloomberg U.S. Mortgage Backed Securities Index is made up of mortgages that were created when rates were very low, and hence are not as vulnerable to prepayment. As such, the negative convexity often associated with MBS would be less of a concern in this market cycle.

Bottom line

Agency MBS valuations are attractive, especially after the March banking crisis. These assets are cheap compared to historical levels, and broadly speaking, spreads have not yet fully recovered. As securities that carry an implicit government guarantee, these investments will also likely hold up much better in a recessionary environment.

Spreads could drift wider in the short term, but starting yields appear to provide a good entry point, especially among current coupon securities. The Fed’s balance sheet run off and the FDIC’s offloading of failed bank assets have been orderly, and as these agencies step away from the market, it should result in a healthier market overall.