With Decade-Low Valuations, Are MBS Worth Another Look for Investors?

The Federal Reserve, which was the largest buyer of mortgage bonds during the most recent quantitative easing program, began its QT initiative in June of last year and has since continued to reduce its holdings of MBS.

At the same time, US banks - another significant buyer of MBS - have also been rapidly decreasing their MBS investments since 2022. The Fed's aggressive interest rate hikes have made it challenging for banks to retain users seeking high-yield assets like money market funds. As a result, there have been significant outflows of deposits from the banking system, which constitutes an essential source of funds for banks' MBS investments. Furthermore, the banking crisis that occurred in March left many U.S. banks facing substantial unrealized losses, and their subsequent efforts to decrease the duration of their portfolios have exacerbated the already sluggish demand for MBS.

Despite narrowing by approximately 30 bp since October's end, spreads on Fannie Mae current coupon bonds - which serve as a proxy for mortgage bonds being created now - are still as high as 159 bp, or 159 bp above a blend of five- and ten-year Treasuries, according to Bloomberg data. This highlights a much wider spread than the 10-year average of roughly 106 bp, indicating that bad news may have already been priced in.

As per JP Morgan data, although some funds have flowed into MMF,US bank deposits have not shrunk in the past four months but have slightly declined since the end of May, increasing by approximately $50 billion. According to Boris Peresechensky, portfolio manager at Orange Investment Advisors, this development “removes at least one barrier to bank purchases”. Conversely, US agency MBS issuance has slowed down this year, resulting in relative stability on the supply side.

Some analysts have noted that due to a significant increase in mortgage rates over the past two years, current slightly lower rates do not provide sufficient incentives for borrowers to refinance. As a result, the risk of borrowers paying off their mortgages early is low, providing greater stability for MBS's future cash flows and earnings.

The Fed's monetary policy shift and decreasing benchmark interest rates are proving to be a “tailwind for the MBS market”. Additionally, lower interest rate uncertainty and bond volatility are providing support to mortgage bonds. According to Bloomberg research, analyzing MBS spreads and the MOVE Index - which represents bond volatility - reveals that each of the past three Fed tightening cycles has been followed by a period of reduced volatility and increased positive sentiment. This trend is expected to stabilize or narrow MBS interest rate spreads, thereby boosting MBS valuations.

Merrill slightly overweighted MBS investments in October and shifted its rating on mortgage-backed securities from neutral to slightly bullish, citing a pickup in MBS spreads as an attractive entry point.

Janus Henderson is actively reallocating capital away from corporate bonds - particularly high-yield bonds - and increasing exposure to mortgage bonds.

John Lovito, Co-Chief Investment Officer of Global Fixed Income at American Century Investments, stated in November that the fund had been increasing its holdings of MBS over the past three to four months.

Additionally, Boaz Weinstein, the founder of Saba Capital Management, has recently expressed optimism for MBS.