The Big Idea
The Great Risk Rotation
Steven Abrahams | May 20, 2022
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.
At least four major asset flows look likely to move through debt markets over the next few years: the Fed ceding several trillion dollars of Treasury debt and MBS to the broader market, banks buying liquid assets with low risk-weights, money managers rotating from Treasury debt and credit to MBS and insurers reallocating from private to public debt. The Great Risk Rotation is underway.
From Fed into private hands
The Fed is about to let several trillion dollars of Treasury debt and MBS roll off its portfolio. Those balances ultimately should flow back into the market as new debt and MBS—Treasury debt through deficit spending, MBS through refi or purchase loans. Most of that debt will find homes in portfolios that will either need to rotate out of other investments or build capacity to hold more assets. The amounts will depend on Fed targets for reserves in the banking system, but it is likely between two to three years away. Up to $720 billion a year of Treasury debt will roll off. And depending on prepayments, up to $420 billion a year in agency MBS will leave. This flow helps set the others in motion.
The Treasury debt flows into a $23.2 trillion public market, but MBS flows into a comparatively smaller $8.2 trillion market. MBS has already repriced substantially ahead of the Fed flows although heavy net supply promises to push spreads wider. Banks, mutual funds, pensions and REITs are the most likely candidates for absorbing the MBS, although each buyer needs to fix issues on its own balance sheets before adding sizable net exposure. While these issues get fixed, MBS spreads remain vulnerable.
From bank efforts to balance risk-weighted assets, LCR and loan demand
US commercial banks, thrifts and credit unions, with nearly $26 trillion in total assets and nearly $7 trillion in debt securities, according to the Fed, have capacity to absorb Fed flows but not the unqualified appetite for now. The reversal of Fed QE promises to slow or reverse the extraordinary balance sheet growth of the last two years, and US commercial bank balance sheet so far this year are roughly flat. Banks have also started reporting loan demand, and loans almost always do more than securities for bank profits and equity prices. Banks also have taken historic unrealized losses in their investment portfolios this year, putting pressure on the ratio of Tier I capital to risk-weighted assets and on liquidity coverage ratios. All of this means banks may want to absorb some of the Fed flow, but only a specific part.
Banks may have use for some of the Fed’s Treasury flow but more likely for the flow of Ginnie Mae MBS. Both have a 0% risk weight, but MBS has spread to banks’ cost of funds. By moving from 20%-weighted conventional MBS to Ginnie Mae, for example, a bank maintains total asset balances but reduces risk-weighted assets. That reduces the denominator and raises the ratio of Tier I capital to risk-weighted assets. Moving from conventional MBS to Ginnie Mae also shifts assets from LCR Level 2A, where 85% count for meeting liquidity tests, to Level 1, where 100% count. And beyond these incentives, loan demand weirdly adds to the value of Ginnie Mae MBS: when a loan rolls onto the books, 100% of the balance counts toward risk-weighted assets, and Ginnie Mae MBS most efficiently helps offset it.
Banks look highly likely to absorb Ginnie Mae MBS flows out of the Fed by reallocating away from conventional MBS. Pressure on conventional MBS spreads should be significant, with Ginnie Mae MBS outperforming.
From asset manager rotations
Actively managed mutual funds hold nearly $6 trillion in debt securities, according to the Fed, with public and private pensions bringing more than $5 trillion. Mutual funds are off to their worst year in performance in at least three decades, and funds and ETFs have seen net outflows since January of $120 billion. These portfolios still look most likely to absorb some of the flow of conventional MBS by rotating out of Treasury, agency and corporate debt. MBS spreads to Treasury debt already look attractive. MBS spreads to corporate debt have widened, but that rotation is probably going to have to wait until concerns about slowing growth or recession add to corporate spread volatility. Anecdotally, some portfolios have started rotating out of Treasury and agency debt into MBS, and others are starting to cover longstanding underweights in MBS. But there’s a long way to go.
Mortgage REITs, with $511 billion in assets, according to the Fed, also may play a role in absorbing conventional MBS flow in part because spreads already are at levels that offer competitive return on REIT equity. Annaly recently raised $645 million of equity, but it also is the only mortgage REIT trading above its most recently quarterly book value.
From insurers managing higher net yield and liquidity
Life and P&C insurers bring $7.1 trillion in cash and investments to the market, including $4.8 trillion in securities and a longstanding appetite for credit, making insurers a likely buyer of credit flowing out of money managers. Insurers’ need for yield has led to a steady increase in private debt for the last decade, but higher rates and wider spreads in public debt lately have started to change the price for trading off liquidity for yield. Anecdotally, some insurers have already stepped back into the public debt markets for the first time in years or in greater size than usual, reflecting the wider spreads. If concerns about slowing growth or recession add to corporate spread volatility and make the asset harder to hold for daily mark-to-market mutual funds, insurance balance sheets would be a natural home.
On June 1, Fed balance sheet normalization gets underway, and the Great Risk Rotation begins.
* * *
The view in rates
Yields have continued to drop in the last few weeks with room on the long end to drop further. Fair value at 10-year and longer maturities still look solidly in the neighborhood of 2.50%. The curve still should invert significantly over the next year with 2-year rates approaching 3.5%. Persistent supply and trade frictions from Russia-Ukraine could force the Fed to go higher than currently priced and push the 2-year note well above current forward rates.
The Fed’s RRP balances closed Friday at $1.99 trillion, a record. The supply of Treasury bills continues to come down, with bills out to mid-July trading at yields below the RRP’s 80 bp rate. Money market funds have little alternative but to put proceeds into RRP.
Settings on 3-month LIBOR have closed Friday at 150 bp, up 9 bp in the last week. Setting on 3-month SOFR have drifted up to 133 bp, up 8 bp in the last week.
The 10-year note has finished the most recent session at 2.78%, down 14 bp in a week. Breakeven 10-year inflation finished the week at 259 bp, down 15 bp on the week. The 10-year real rate finished the week at 20 bp, up 1 bp on the week. Real 10-year rates only recently have turned positive since the start of pandemic.
The Treasury yield curve has finished its most recent session with 2s10s at 20 bp, 14 bp flatter on the week, and 5s30s at 19 bp, flatter by 2 bp on the week.
The view in spreads
Spreads still look broadly biased to widen in both MBS and credit. Nominal MBS spreads will either have to trade wider than the average investment grade corporate issue, or corporate spread volatility will have to become unmanageable for mutual funds before MBS becomes compelling relative value for total return investors. Of the major spread markets, corporate and structured credit is likely to outperform for the next few months, as it has generally since March 2020. But a turning point is coming. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy—including mutual funds, pensions and insurers. The credit markets have a diversified base of buyers while the only net buyers of MBS during pandemic have been the Fed and banks.
The view in credit
Credit fundamentals look strong for now but will almost certainly soften later this year as the Fed dampens demand and growth begins to slow. Corporations have strong earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. It will be important to watch inflation and see if costs begin to catch up with revenues. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low.