Seizing the opportunity in US agency MBS

Since late 2022, US agency mortgage-backed securities (MBS) have presented a compelling investment opportunity. A variety of factors have driven the attractive valuation and significant spread widening, including the Federal Reserve's (Fed’s) quantitative tightening and the regional banking crisis. Despite these challenges, the underlying fundamentals of MBS remain supportive, with low negative convexity and strong housing market dynamics.

Summary of key investment themes

• Valuation Anomaly: The spread of agency MBS to 5 to 10-year Treasuries reached a historically wide level in late 2022, offering an attractive entry point for investors.
• Favorable Fundamentals: The diminishing negative convexity and strong US housing market dynamics, characterized by low prepayment speeds and limited organic supply, enhance the appeal of MBS.
• Strategic Investment Approach: We implemented a phased investment strategy, capitalizing on multiple entry/exit opportunities as spreads widened and tightened. We also calibrated the optimal relative value between Fannie/Freddie and Ginnie Mae bonds and across the coupon stacks.
• Positive Outlook for 2025: The outlook for MBS in 2025 remains optimistic, supported by factors such as moderating interest rate volatility, continued strong demand from money managers, and the potential for increased bank and foreign buying.
• Key Risks: While there are potential risks, such as sharp interest rate increases or increased MBS supply, we believe these risks are manageable and outweighed by the favorable investment thesis.

Seizing the opportunity

In late 2022, a unique investment opportunity emerged in agency MBS. The spread of agency MBS relative to 5 to 10-year Treasuries widened significantly, presenting a compelling valuation anomaly. This widening was primarily driven by the Fed's quantitative tightening (QT) and the regional banking crisis that unfolded in early 2023. As a result, major market participants, including the Fed and banks, exited the market, leading money managers to demand higher spreads.

Despite these challenging market conditions, the fundamentals of MBS remained strong, supported by healthy household balance sheets. Meanwhile, housing market activities were in the doldrums because of the lock-in effect for existing homeowners and the lack of housing affordability for renters due to elevated housing prices and high mortgage rates. The low negative convexity of MBS driven by low prepayment speeds, coupled with limited organic supply, further enhanced the appeal of this asset class.

To capitalize on this opportunity, we implemented a phased investment strategy. Our initial investment in October 2022 targeted the production coupon MBS. We deemed this the most attractive segment of the market due to its favorable risk-reward profile with spreads at over two standard deviations cheaper than the historical index average (see Exhibit 1). As spreads widened further in May and October 2023, we executed additional purchases, strategically allocating capital to potentially maximize returns. We realized gains on half of our MBS holdings in September 2024 as the valuation renormalized closer to fair value and the interest rate volatility declined, benefiting from the Fed’s interest rate cuts. In October 2024, we again took advantage of spread widening close to two standard deviations as the Treasury market sold off and interest rate volatility rose amid resilient economic growth. Currently, the spread is around one standard deviation cheap at just over 130 basis points (bps) in its 10-year history. We view 6% coupon as the most attractive sector for its relatively short duration, high carry, and wide option-adjusted spread (OAS). We also prefer Ginnie Mae to conventional MBS based on our relative value and interest rate/spread shock analysis.

The road ahead

As we look ahead to 2025, the outlook for agency MBS remains optimistic. Several key factors support this view:

1. Moderating Interest Rate Volatility:

• The Fed's effective taming of inflation and expected rate cuts should lead to a decline in interest rate volatility. Elevated Treasury yields start to present value for long-term investors. A more range-bound Treasury market bodes well for declining interest rate volatility.
• Reduced interest rate volatility benefits MBS, with embedded short positions in volatility.

2. Least negative convexity: Agency MBS are starting to exhibit almost positive convexity, which is historically unprecedented, providing great fundamental value (see Exhibit 2).

3. Strong Demand Dynamics:

• Money Managers: Continued strong demand from money managers, driven by attractive yields and favorable risk-adjusted returns, combined with a robust pace of inflows into fixed income funds will support MBS prices.
• Banks: The potential end of QT, more clarity on deregulations, attractive yields on MBS, and the ongoing excess deposit creation alongside relatively weak loan growth could lead to increased demand for MBS from banks.
• Foreign Buyers: Foreign investors, particularly from Japan, may increase their allocations to MBS due to favorable yields. In addition, currency hedging costs should become less onerous as the Fed cuts rates and the Bank of Japan hikes further.

4. Favorable Supply Dynamics: Home prices peaked in March 2022, and the rate of price increases slowed to 4.37% year-over-year by September 2024. More important, the bifurcation between slow housing activities, including home sales, new home starts, etc., and elevated home prices continues. The major driver behind this anomaly is the ongoing shortage of existing homes, which is due to the lock-in effect of existing homeowners combined with the lack of housing affordability due to high mortgage rates and high prices. Both the Mortgage Bankers Association (MBA) Purchase Index and Refinance Index are at historical lows (see Exhibit 3). The lion’s share of mortgage borrowers is still out of the money to refinance. Slow housing activities indicate lower organic supply of MBS, slower prepayment speed, and less paying down of the Fed’s MBS holdings. These conditions are more favorable for production and premium coupon MBS than discount coupon MBS.

5. MBS Still Offer Attractive Valuation Anomalies:

• Cheaper across Spread Products: The two charts below from Goldman Sachs Global Investment Research show the percentile ranks for spreads and yields across spread products from 2010 to the present (see Exhibit 4). Agency MBS basis stands out as the widest and cheapest.

• Cheaper versus Investment Grade Corporates: The spread between investment grade (IG) corporate bonds and MBS OAS is still rather tight. We believe there remains more room for MBS spreads to tighten relative to IG corporates since the corporate bond valuations are richer than the MBS based on the historical pattern (see Exhibit 5). Money managers appear to be increasingly allocating new inflows into MBS versus corporate bonds.

Key risks and mitigating factors

While we believe the outlook for MBS is positive, it is important to acknowledge potential risks:

• Sharp Increase in Interest Rates: A sudden and significant increase in interest rates could negatively impact MBS prices with heightened rate volatility. However, the Fed's commitment to price stability and the expectation of a soft landing for the economy should help mitigate this risk.
• Increased MBS Supply: A surge in mortgage originations, driven by a sharp decline in interest rates or a significant policy boost to home sales, could increase MBS supply and negatively impact prices. However, the resilient economy and sticky inflation may limit this risk.
• Risk of Prolonged Weak Bank Demand: There is a risk that bank demand can stay weak for longer if the Trump administration’s policies boost loan growth, eliminating the need for banks to buy MBS. In addition, Trump’s proposed deregulation may create more uncertainty. If bank capital requirements from BASEL III turn out to be less restrictive than expected, there is a risk that banks may not need to focus as much on adding agency MBS with low risk-weighting in capital treatment.
• Increased Probability of Government-sponsored Enterprises (GSEs) Exiting Conservatorship: The Trump administration is likely to revive the pursuit of GSE reform or privatization, putting the explicit government guarantee at risk. However, while this would be a seismic, negative event for the MBS market, we see it as having very low probability. One case in point would be it may make the lack of housing affordability even worse. Our positioning with a focus on the Ginnie Mae sector should protect us from this risk.

Conclusion

We believe US agency MBS offer a compelling investment opportunity, driven by attractive valuations, strong fundamentals, and favorable market dynamics. As we move into 2025, we remain optimistic about the prospects for this asset class, positioning it as a valuable addition to diversified global bond portfolios. By carefully considering the key risks and implementing a prudent investment strategy, we will continue to seek to capitalize on the potential rewards offered by this asset class.