The Big Idea

Mutual fund redemptions drive MBS wider

| October 20, 2023

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.

The latest round of widening in MBS spreads coincides with the broad return of redemptions to actively managed mutual funds. Active funds saw redemptions following poor performance last year, and poor performance this year has brought them back. Unfortunately for MBS partisans, the asset’s liquidity makes selling a relatively easy way to raise cash. The dynamic promises to change MBS durations, change the relationship between TBA and specified pools and open the door to rotating out of much tighter assets.

Mutual fund redemptions trigger MBS sales

After moving in rough parallel with credit through the first half of the year, MBS spreads recently have widened sharply. The average option-adjusted spread (OAS) on the Bloomberg MBS index since the end of August has ballooned out 28 bp while OAS on the Bloomberg investment grade corporate index only widened by 9 bp (Exhibit 1). The MBS OAS is now wider than 99% of sessions in the last five years with the corporate OAS wider than 62%.

Exhibit 1: MBS continues to widen against corporate debt

Source: Bloomberg, Santander US Capital Markets

Although runoff from the Fed MBS portfolio and lower demand from banks had widened MBS spreads at different times early this year, the latest widening comes as bond funds and ETFs face rising redemptions. Poor investment returns in bond mutual funds triggered heavy redemptions last year, but the sector had seen good performance and inflows for most of 2023. But rising rates since April have taken their toll on performance and assets under management (AUM). Flows into bond funds and ETFs peaked in July have slowly tapered off, with outright redemptions starting as bond index returns in recent weeks turned negative for the year (Exhibit 2). As of October 19, the Bloomberg aggregate bond fund index had dropped 3.44% for the year.

Exhibit 2: Inflows follow good fixed income performance, outflows follow bad

Source: Bloomberg, Santander US Capital Markets

The redemptions have come almost entirely from actively managed bond funds, with ETFs continuing to pick up AUM (Exhibit 3). Actively managed funds tend to attract retail investors that often buy and sell positions based on recent performance. ETFs have a larger share of institutional investors less likely to react to recent performance.

Exhibit 3: Recent net redemptions have come almost entirely from active funds

Note: Flows into and out of taxable bond mutual funds and ETFs.
Source: Investment Company Institute, Santander US Capital Markets

In fact, work by researchers at the University of Pennsylvania shows investor redemptions from actively managed funds pick up under a trifecta of circumstances:

  • As expected performance suffers,
  • When a fund portfolio holds relatively liquid assets, or
  • When market liquidity gets worse

Investors have incentives to get out of a fund early under these circumstances or else risk getting stuck with the least liquid and potentially least valuable assets. All three circumstances likely describe mutual funds and fixed income markets in recent weeks.

Actual or anticipated redemptions have put pressure on fund liquidity, and MBS along with Treasury debt are typically the most easily liquidated assets. That likely explains the recent sharp widening in MBS and the relative stability in credit.

Impact on MBS duration, specified pools and relative value

In past markets dominated by the Fed or banks, the dynamics of mutual fund redemptions would have limited impact on MBS. But in the absence of the Fed and banks, mutual funds have become important marginal influences on MBS pricing. That implies a mix of unique risks and opportunities in the current market:

  • Effects on MBS duration. Since poor mutual fund performance usually follows from rising interest rates, MBS spreads are at risk of widening further if interest rates continue to rise—especially if they rise quickly. MBS, all else equal, consequently should trade to longer effective durations than usual as rates go up. Conversely, MBS spreads should eventually tighten as rates drop, although it is unlikely that flows into bond mutual funds and fund demand for MBS would rise meaningfully without a few weeks or months of good performance.
  • Effects on TBA and specified pool spread The TBA market is far more likely to bear the brunt of mutual fund MBS selling than the specified pool market, possibly changing the relationship between TBA and specified pool duration. Mutual funds are likely to sell TBA positions first primarily because TBA is more liquid. But it is also likely true that funds have carefully collected their specified pool positions and have meaningful underweights or overweights. And recent work by researchers at the University of Chicago suggests fund managers are reluctant to sell positions where the manager has strong conviction.
  • Effects on relative value. Assets trading a wide spreads can always get wider, and assets trading at tight spreads can always get tighter. But investors should consider the places where trading tight assets for wide ones makes sense. MBS is clearly trading wide, and arguably, at the recent 81 bp OAS on the MBS index, at levels wide of fair value. Certain parts of the investment grade corporate market are trading as tight levels. Some of these tight corporate sectors that look like poor value relative to MBS:
    • Energy
    • Metals and mining
    • Pharmaceuticals
    • Railroads
    • Restaurants
    • Transportation services

Redemptions are likely to pick up in the next few weeks as retail investors digest the impact of the last surge to higher rates. But wider spreads on MBS have opened the door to eventually rotating out of tight corporate positions, especially as pressure on liquidity eases.

* * *

The view in rates

After Fed Chair Powell’s remarks in the last week suggesting higher interest rates and conflict in Ukraine and Gaza had tightened financial conditions, OIS forward rates now see almost no chance of another hike from the Fed in November and slightly more than a 10% chance of one in December. The same forwards then see rates roughly steady through April and then declining 67 bp through December 2024. On the expected timing of a final Fed hike has changed in the last few weeks. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer than expected, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key market levels:

  • Fed RRP balances closed Friday at $1.14 trillion as the facility continues a sharp October decline, down $13 billion in the last week but down $419 billion this month. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
  • Setting on 3-month term SOFR traded Friday at 540 bp, roughly unchanged in the last week
  • Further out the curve, the 2-year note closed Friday at 5.07%, up 2 bp in the last week. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.91%, up 30 bp in the last week. At that yield, the 10-year note looks compelling relative to many risk assets.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -16, steeper by 28 bp in the last week. The 5s30s closed Friday at 22 bp, steeper by 11 bp in the last week.
  • Breakeven 10-year inflation traded Friday at 247 bp, up by 12 bp in the last week. The 10-year real rate finished the week at 245 bp, up 18 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 163 bp, wider by 9 bp in the last week and the first material week-over-week widening in a while. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 189 bp, wider by 3 bp in the last week. Par 30-year MBS TOAS closed Friday at 86 bp, wider by 6 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile since June and trending wider. And the start of mutual fund redemptions should make MBS spreads more sensitive to the direction of rates, widening as rates rise and eventually tightening as rates fall.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, but a lot will depend on how long rates remain high. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

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

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