Agency mortgage-backed securities (MBS) remain an important complement to a core fixed income portfolio, but the uncertainty of the current environment, and the withdrawal of central bank accommodation, bring the topic of MBS performance expectations to many of our conversations with investors.
Agency MBS are pools of securitized US mortgage loans that are guaranteed by government agencies. These securities are highly liquid (second only to US Treasurys) and may provide a yield advantage with no relative credit risk. The yield advantage compensates for prepayment risk and the uncertainty of MBS cash flows, as US mortgage borrowers can prepay principal in full or in part at any time.
Rising rates can improve MBS fundamentals
In an environment of rising rates, which generally many investors fear, the prepayment fundamentals of MBS securities should improve as homeowners are less likely to refinance. Over the near term, the duration of MBS securities extends, but the timing of cash flows can become more predictable and the yield advantage more attractive. The table illustrates the performance of US MBS during years of rising rates, going back to the early 1980s.
MBS performance in years with higher rates
Security selection focused on fundamental research and capital preservation can further improve outcomes. Active management leverages the depth and breadth of the MBS market, while the liquidity advantage featured with this market offers transactional efficiencies for risk management and tactical relative value opportunities. Certain securities may benefit when rates rise, and may offer a stable source of income and potential price appreciation. For holders of higher coupon seasoned premium securities, slower prepayments make the higher coupon income stream more valuable. As a result, these securities tend to outperform other similar duration fixed income sectors. Floater agency MBS securities also may benefit, as the coupon resets to higher yields. Deep discounted securities should have less extension risk, while interest-only securities have attractive yield/duration profiles and price-upside potential if rates rise.
Ion Dan is portfolio manager, senior structured products analyst & trader at Macquarie Investment Management
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The Bloomberg Barclays 10-Year U.S. Treasury Bellwethers Index is composed of public obligations of the U.S. Treasury with a maturity of 10 years.
The Bloomberg Barclays US Treasury Intermediate Index is a subset of the Bloomberg Barclays US Treasury Index, representing US Treasury obligations with maturities from one year up to (but not including) ten years.
The Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index measures the performance of agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgage) issued by the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Association (Freddie Mac), and Government National Mortgage Association (Ginnie Mae).