The Big Idea

Rotating into agency MBS

| June 3, 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.

The Fed over the next few months will start letting Treasury debt and MBS roll off its portfolio at a pace of up to $1.14 trillion a year, setting in motion a Great Risk Rotation. Perhaps the biggest known unknown in that asset flow is the future home of the conventional MBS sent out into the world by the Fed. It is likely to settle somewhere in the portfolios of mutual funds, pension funds and other benchmarked investors, but only if MBS looks like good relative value against Treasury debt or credit. By that measure, it is time to start rotating into MBS.

Good value against Treasury debt

Investors can measure agency MBS against Treasury debt through nominal or option-adjusted spreads, and both point to good MBS value. The nominal spread of par 30-year MBS sits at 118 bp, well above the Fed QE era median of 103 bp (Exhibit 1). The option-adjusted spread on par 30-year MBS sits at 36 bp, also well above the QE era median of 27 bp. And for investors gauging all MBS against the Treasury curve, the option-adjusted spread on the Bloomberg/Barclays US MBS Index sits at 34 bp, just above its median of 33 bp.

Exhibit 1: Measures of MBS spread paint a good picture against Treasury debt

Source: Bloomberg, Amherst Pierpont Securities

MBS looks like fair value or better by any of these measures, with coupons around par more attractive than the dominant share of the market trading below par. The better value around par almost surely reflects the absence of net buying from the Fed and banks, the only net buyers over the last two years and buyers that typically concentrated in production coupons.

These spreads also importantly reflect most of the biggest risks that faced MBS at the beginning of the year—the magnitude of potential Fed tightening, the pace of balance sheet normalization, the risk of MBS sales by the Fed. There are still broad and reasonable differences of opinion about when the Fed might sell MBS, the magnitude of sales or whether the Fed will sell at all. There is still risk of heavy net MBS supply from new originations. At a longer horizon, it is unclear how far down the Fed will draw its MBS balances.

MBS in May posted its first month of positive excess return this year, with tighter spreads suggesting an important margin of investors seeing at least fair-to-better value for the risk. Most mutual funds and pensions have run Treasury debt and MBS below index allocation for years. It looks reasonable to push the Treasury allocation lower and add to MBS.

Good relative value against credit

Credit has looked like the best call on relative value since the start of pandemic, but almost certain slowing in the economy and the rising risk of recession in the next few years changes the calculus. It is not as if credit will fall apart. Many corporate balance sheets start with strong cash positions, good trailing earnings and—at least for investment grade issuers—fixed debt with maturities that stretch out for years. But more than 50% of outstanding investment grade debt is ‘BBB’ or lower and slowing growth should raise concern about downgrades and kick up spread volatility. Relative to spreads in MBS, credit does not compensate for the significant difference in likely spread volatility between the sectors.

Spreads between MBS and corporate debt fall into distinct regimes around the 2008 Global Financial Crisis. Before the crisis, nominal MBS spreads ran wide of corporate debt (Exhibit 2). But after the GFC with the Fed heavily invested in MBS, nominal spreads generally ran tight to corporate debt.

Exhibit 2: MBS and corporate spreads fall into pre-and post-GFC regimes

Source: Bloomberg, BoAML US Corporate Index OAS from FRED, Amherst Pierpont Securities

It might be the case that wider spreads in corporate debt came from an increasing share of the index in ‘BBB’, but the same regime shift shows in the spread between MBS and ‘A’ corporate debt (Exhibit 3). MBS traded wide to ‘A’ corporate debt before the GFC and roughly even with ‘A’ debt afterwards.

Exhibit 3: MBS and ‘A’ spreads also show a regime shift around the GFC

Source: Bloomberg, BoAML US Corporate ‘A’ Index OAS from FRED, Amherst Pierpont Securities

The other regime shift around the GFC is the difference in spread volatility between MBS and corporate debt. Before the GFC, the volatility of corporate spreads was generally less than the volatility of MBS (Exhibit 4). After the GFC, corporate spreads generally became more volatile than MBS. Corporate spreads showed more volatility around the European sovereign debt crisis in 2011, the energy crash of 2015 and 2016, the market stress in late 2018 and in March of 2020. So wider corporate spreads post-GFC may reflect both more credit risk and greater spread volatility—arguably two sides of the same coin.

Exhibit 4: Corporate spread vol went from 1x MBS or less before GFC to 1x or more afterwards

Note: Data shows the ratio of the rolling 90-day standard deviation of ICE BofAML US Corp Index OAS to the rolling 90-day standard deviation of the par 30-year MBS spread to the 5/10 Treasury.
Source: ICE BofAML US Corporate Index from FRED, Bloomberg, Amherst Pierpont Securities

Given the current spread between MBS and corporate debt—or lack of spread with the nominal spread on MBS and ‘A’ debt almost identical for now—corporate debt spreads look like poor compensation for the risks from slowing growth. The New York Fed’s US Corporate Bond Market Distress Index has picked up substantially from where it started the year, especially for investment grade corporate bonds. The index is reflecting deteriorating trading conditions in the secondary market, higher default-adjusted spreads and gaps between primary and secondary pricing. As growth almost certainly slows in the second half of the year, corporate market conditions are likely to slide further and spread volatility pick up.

Moving a corporate allocation takes time, but the spread and liquidity in MBS makes the current market a good place to start. Mutual funds and pensions have allocated into credit at weightings well above the index. It is time to start drawing that down and adding to positions in MBS.

* * *

The view in rates

Concerns about inflation have pushed up yields in the last week or so. That should make the Fed even more determined to hike aggressively. Fair value at 10-year and longer maturities still looks solidly in the neighborhood of 2.50%. But an aggressive Fed 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 Monday at $2.03 trillion, just short of the record on May 23 of $2.04 trillion. The supply of Treasury bills continues to come down, with bills through June 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 163 bp. Setting on 3-month term SOFR have drifted up to 147 bp.

The 10-year note has finished the most recent session at 2.93%, a bounce off late May lows. Breakeven 10-year inflation finished the week at 276 bp, also a bounce off late May lows. The 10-year real rate finished the week at 18 bp, roughly flat in recent weeks. The bounce in nominal yield largely reflects higher inflation expectations.

The Treasury yield curve has finished its most recent session with 2s10s at 28 bp and 5s30s at 15 bp. Both curve have meandered in their current range through May.

The view in spreads

The equilibrium between MBS and credit looks ripe for change. Nominal MBS spreads incorporate big components of the risks that faced the sector at the start of the year—the Fed path, balance sheet normalization, the risk of MBS sales. Credit spreads seem insufficient to cover the spread volatility likely as growth slows and concern about recession grows. A turning point is coming.

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.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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