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Rebalance after the rally in 30-year MBS

admin | August 7, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

In the first few trading sessions after the July FOMC, the option-adjusted spread on 30-year par MBS tightened from 56 bp to 42 bp, a 14 bp move. The market has clearly raised its expectations for Fed QE. Based on past spread response to Fed buying, the move is equivalent to more than $400 billion in additional Fed buying or 6% of the outstanding market. At the Fed’s current pace of accumulating $40 billion of MBS monthly, the market has effectively extended its timeframe for Fed purchases by 10 months. After this MBS rally, investors should consider rebalancing into other corners of MBS, CMBS and investment grade credit.

The market reprices for further Fed accommodation

The MBS market response lines up with other markets in the last week that priced in a more accommodative Fed for longer. The fed funds futures and OIS markets last week began pricing slightly negative rates for 2022 for the first time (Exhibit 1A). Implied forward rates in the Treasury market became lower and flatter (Exhibit 1B).

Exhibit 1: The market repriced after the July FOMC to lower rates over a longer horizon

Source: Bloomberg, Amherst Pierpont Securities

The MBS market historically has priced in expected Fed buying quickly. A 1% increase in the Fed’s share of outstanding MBS has corresponded to an average tightening of 2.3 bp (see A bullish case for the MBS basis, Jun 12). The initial 14 bp move in MBS spreads consequently corresponds to a share increase of more than 6%. With $6.77 trillion in MBS outstanding, that corresponds to $406 billion in Fed purchases.

The move leaves 30-year MBS tight to 15-year MBS

The move in 30-year MBS has left it unusually rich to a range of benchmarks, including 15-year MBS. The OAS on par 30-year MBS closed as much as 7 bp tighter than the OAS on par 15-year MBS before finishing Friday at equal OAS (Exhibit 2A). Over the last five years, the OAS on 30-year MBS has closed more than 7 bp tighter to 15-year in less than 2% of sessions. The nominal spread of par 30-year MBS to the Treasury curve is now 13 bp wider than the nominal spread of 15-year paper (Exhibit 2B). Nominal spreads between the sectors over the last five years have only been tighter in less than 5% of sessions. For some investors, relative value has swung to 15-year paper (see Sell 30-year 2.0%s, pick up carry or convexity in 15-year paper).

Exhibit 2: Spreads between 30- and 15-year MBS in the last five years have rarely been tighter

Source: Bloomberg, Amherst Pierpont Securities

The move leaves 30-year MBS tight to private and agency CMBS

The tightening in 30-year spreads also leaves the sector ahead of both private and agency CMBS. Both private and agency CMBS spreads have roughly moved sideways since the July FOMC (Exhibit 3).

Exhibit 3: 30-year MBS spreads moved tighter with CMBS moving sideways

Source: Bloomberg, Amherst Pierpont Securities

The move leaves 30-year MBS tight to investment grade credit

Par 30-year MBS has also tightened to investment grade corporate debt and, by extension, investment grade structured credit. With 30-year nominal spreads at 82 bp and average cash IG spreads at 130 bp, the 48 bp gap is relatively wide (Exhibit 4). The spread has only been wider over the last five years in 25% of sessions.

Exhibit 4: The spread between cash IG and 30-year par MBS looks wide

Source: Bloomberg, Amherst Pierpont Securities

An opportunity to rebalance

For portfolios that allocate by market value, the recent performance of 30-year MBS has likely left many market-value overweight relative to other assets, and those portfolios should consider rebalancing. In line with earlier recommendations (see Lessons from asset returns in the second quarter, Jul 10), take a maximum underweight in Treasury debt (see Short duration, Jul 24), rebalance to neutral in agency MBS with a small shift from 30-year paper into 15-year, and stay overweight investment grade corporate and structured credit.

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The view in rates

Real rates continue their steady decline as the market upgrades expectations for inflation and its conviction that the Fed will hold rates down for a long time. The current 0.56% rate on 10-year Treasury debt implies an average real rate of -105 bp and inflation of 161 bp. Real rates should go even lower and breakeven inflation higher as the Fed likely shows more willingness to let inflation return to target and go higher. Although Fed Chair Powell noted concern about disinflation after the July FOMC, the market thinks the Fed will nevertheless do its job and push inflation back towards its 2% target and beyond. Treasury debt may have value for safety and liquidity, but it is likely to produce limited if any real returns.

The view in spreads

As the Fed continues to absorb high quality assets and spreads tighten, investors will have to move to the next tier of higher risk to get sufficient spread. Spread compression across rating categories or credit quality should continue as long as QE is in place and as long as US deficit spending keep driving up the net supply of Treasury debt. There is fundamental risk in the most leveraged corporate balance sheets, and only there might spreads continue lagging the rest of the market.

The view in credit

The downside in leveraged credit outweighs the upside for now. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Elevated unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals for now. The course of leveraged corporate and consumer credit also depends on renewal of fiscal support and other programs.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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