Mortgage-Backed Securities: A Timely Opportunity
Uncertainty over the direction of interest rates has led to a significant widening of spreads in the agency mortgage-backed securities market, creating a potentially attractive opportunity for investors.
Powerful but oscillating technical forces have driven the mortgage-backed securities market in recent years. First, in the wake of the pandemic in 2020 and 2021, the U.S. Federal Reserve (Fed) and banks added roughly $2 trillion in mortgage-backed securities (MBS), crowding out other investors. In 2022, as the Fed reversed course and began raising rates to douse escalating inflation, relative value buyers began to dominate demand. Today, with the Fed taking a steadier course, and with MBS spreads and yields at or near their most attractive levels in more than a decade, we believe valuations are at a level that create a timely opportunity.
Where the Market is Now
The Fed’s 18-month hiking cycle and uncertainty around the effects of that policy on economic growth and inflation have led to a sustained period of interest-rate volatility. This has significantly widened agency MBS spreads versus U.S. Treasuries and corporates, presenting an attractive opportunity for investors to increase agency MBS weightings in core asset allocations. Currently, agency MBS represents about 20% of the U.S. fixed income market, second only to U.S. Treasuries in size and liquidity; it also represents about 25% of the Bloomberg Barclays Aggregate Index.
MBS spreads1 versus Treasuries have been trading between 160 and 190 basis points (bps), versus a 10-year average spread of 103 bps, levels that are exceedingly unusual (in the 99th percentile)2. Option-adjusted spreads (OAS), which account for the embedded options in which investors are short, currently are at about 65 bps, versus a 10-year average of 14 bps, putting that measure in the 99th percentile. Valuations rarely have been this wide, and we have only seen these levels twice since the global financial crisis—when pandemic shutdowns began, and during the spate of regional bank failures in early 2023.
1. Source: Current coupon MBS is derived from MBS coupons that trade above and below par. Current coupon 30Y MBS spread is quoted vs. a blended 5 and 10-year U.S. Treasury rate.
2. Source: As of October 31, 2023.