In the MBS and credit competition, the tables have turned

Steven Abrahams | September 13, 2024

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.

Through most markets since mid-2020, returns in corporate and structured credit have topped those in sectors mainly sensitive to interest rates, including agency MBS. But since June the performance of risk assets has clearly changed, with MBS tighter and corporate and structured credit wider. With the economy slowing and recent MBS demand and supply trends likely to stay in place, MBS should keep performing well.

The shift in asset spreads since June tells the story. The option-adjusted spread on Fannie Mae 30-year MBS stood at the 49th percentile of its 5-year range at the end of June but today stands at the 24th percentile (Exhibit 1). Ginnie Mae 30-year MBS and even agency CMBS are also tighter. In contrast, the OAS on investment grade industrial names, stood at the 16th percentile of its 5-year range at the end of June but now stands at the 32nd percentile. Other sectors of investment grade and high yield credit along with private CMBS have also widened. On spread alone, MBS has outperformed corporate and structured credit.

Exhibit 1: Credit has widened since June, MBS tightened

Note: Charts shows the current OAS of each sector as a percentile of its 5-year distribution. A rank of 100% would mean the widest spread of the last five years, and a rank of 0% would mean the tightest. OAS based on Bloomberg indices for each sector.
Source: Bloomberg, Santander US Capital Markets.

The relative performance of broad asset classes never amounts to just a few things. But the simplest explanation for the recent reversal of fortune is the rising concern about credit in a slowing economy and the improvement in bank and money manager demand for MBS.

Improved demand for MBS

The demand side of MBS has slowly started to support spreads this year, with demand from banks, money managers and foreign investors offsetting the continuing decline of the Fed portfolio.

Stable-to-improving bank demand

Bank demand for MBS has stopped falling this year and started edging up. Bank holdings of outstanding agency MBS peaked around 35% in early 2022 as the Fed started hiking but fell to 28% by the end of 2023, helping widen MBS spreads in the process (Exhibit 2). Bank share has since gone up marginally in the first quarter of 2024, down marginally in the second quarter and moved up since June from 28.0% to 28.4%. Bank demand for MBS should remain healthy as the economy slows and bank lending ebbs, although proposed regulations that would make banks more sensitive to interest rate risk look likely to keep that demand focused on securities with shorter duration and less negative convexity, such as CMO floating-rate classes.

Exhibit 2: Bank share of MBS has stabilized and started to edge up

Source: eMBS, Federal Reserve, Santander US Capital Markets

Steady money manager demand

Money manager and ETF share of MBS is not as transparent as banks’, but steady inflows point to good accumulation of MBS. After ending last year with a run of net outflows, actively managed fixed income funds and ETFs have pulled in $307 billion of AUM so far this year (Exhibit 3). In aggregate, the inflows likely get allocated in proportion to the 26.3% MBS par weighting in the benchmark Bloomberg US Aggregate Index. That implies $81 billion in net demand from funds and ETFs or nearly 0.9% of current outstanding MBS. Since market and fund relative performance tends to attract more inflows, the 4.74% return on the index so far this year should keep inflows coming.

Exhibit 3: Inflows to active fixed income funds and ETFs have also helped MBS

Source: ICI, Bloomberg, Santander US Capital Markets

Signs of continuing foreign demand

Finally, foreign interest in MBS also seems healthy, which is important for the largest category of investor after banks and the Fed. Demand from Asia and other parts of the world anecdotally keeps growing, although MBS holding get reported through the Treasury International Capital System with nearly a 1-year delay. Foreign demand feels solid, although timely and accurate numbers are hard to get.

Offsetting runoff in the Fed portfolio

The demand for from banks, money managers and foreign portfolios has helped offset the continuing absence of the Fed. Since peaking at 32% of outstanding agency MBS in March 2022, Fed share has declined to nearly 25% today and should continue declining even after QT ends. Past work by the Fed has argued that every 1% drop in Fed share of MBS should widen spreads on average by nearly 2.3 bp, contributing to the weak performance of MBS over the last few years. The Fed has often described its preference for a portfolio of only Treasury debt, so MBS is likely to continue to run off and get replaced by Treasuries. The pace of runoff could even accelerate if interest rates ever drop low enough to spur refinancing in the Fed’s pass-throughs, which have a 2.56% net coupon and 3.29% gross mortgage rate for 30-year paper. With conventional 30-year mortgage rates now near 6.50%, that’s a long way away. But it’s a risk nevertheless.

Exhibit 4: Fed share of outstanding MBS should continue to decline

Source: eMBS, Federal Reserve, Bloomberg, Santander US Capital Markets

A little help from supply

MBS supply is also helping spreads, but only a little bit. The outstanding balance of MBS has grown 0.76% in the last three months, only slightly below the average 3-month period since mid-2009 of 0.94%. Even though absolute existing homes sales are running near their lowest levels of the last quarter century, rising average loan balances and good new home sales have kept net new principal flowing into the market. The case that low net supply is helping materially tighten spreads is hard to make.

Exhibit 5: Agency MBS supply growth is only slightly lagging its 15-year average

Source: eMBS,, Santander US Capital Markets

Plausible factors that could further tighten MBS spreads

Several things could improve MBS spreads from here beyond the current demand and supply trends:

• Recession and tightening of bank lending. This would dial bank demand for MBS up significantly, although this path looks unlikely. A slowing economy should keep banks cautious about lending and encourage reallocation of deposits and other cash into securities, but a sharp slowdown or outright recession would likely accelerate deposit growth, tighten lending and ramp up securities demand.
• Normalization of Fed policy rates. Fed easing should bring the yield advantage of cash down from current high levels and eventually encourage cash to take risk, including duration, credit and MBS convexity risk. This shift could take a while, but with a record $6.3 trillion in cash sitting in money market funds, even a modest move into risk assets could help MBS spreads.

Factors that could widen MBS spreads

Several things could weaken spreads from here beyond current circumstances:

• Growth and loosening of bank lending. If soft landing gives way to growth above trend, banks will likely reallocate marginal cash from securities to loans, which usually are more profitable and better for raising equity value. Securities demand, including for MBS, would fall.
• Bank selling as rates fall. Several banks—Truist and KeyBank, among the largest and most notable—have recently sold MBS in part to reduce negative convexity on the balance sheet and better manage interest rate risk. If rates drop and bring the value of portfolio MBS closer to par, the loss a bank might incur for portfolio rebalancing will go down and possibly encourage more rebalancing. A drumbeat of bank restructuring or the risk of that could soften spreads in MBS.

Positioning

For portfolios investing for total return, the case for MBS is as constructive as it has been in years. Bank and money manager appetite along with foreign buying is offsetting pressure from Fed runoff while the risk of a slowing economy is raising concern about credit. MBS should continue to perform well relative to corporate and structured credit. The position favored in these pages repeatedly since mid-2020, over-allocating to credit and under-allocating to MBS, is no longer the best trade in the market.

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The view in rates

Most of the bullish news in rates is largely priced in, arguing for now for a neutral position in rates. As of Friday, fed funds futures priced in 120 bp of easing this year and a total of 254 bp through 2025, implying fed funds at the end of next year at 2.80%. That is slightly below a pace of 25 bp cuts at each meeting through December 2025. US Chief Economist Stephen Stanley sees that pace as aggressive for now. But markedly weak data could accelerate easing in 2025. As fed funds head toward 3%, the front end of the yield curve should drop to reflect the lower policy rate with the 10-year and longer end of the curve moving much more slowly if at all. Opportunities to outperform the broad market have shifted from rate position to spread positioning.

Other key market levels:

• Fed RRP balances closed Friday at $284 billion, down $15 billion in the last week. RRP balances bounced between $400 billion and $500 billion from the start of March until the end of July. Initially, better yields in T-bills drew cash out of RRP, but those yields have dropped in anticipation of Fed cuts. Now better yields in Treasury and MBS repo are the draw.
• Setting on 3-month term SOFR closed Friday at 494 bp, unchanged on the week.
• Further out the curve, the 2-year note closed Friday at 3.57%, down 11 bp in the last week. The 10-year note closed at 3.65%, down 7 bp in the last week.
• The Treasury yield curve closed Friday afternoon with 2s10s at 7 bp, steeper by 1 bp in the last week, keeping an end to a 2s10s inversion that started in July 2022. The 5s30s closed Friday at 55 bp, steeper by 2 bp over the same period
• Breakeven 10-year inflation traded Friday at 208 bp, up 5 bp in the last week. The 10-year real rate finished the week at 157 bp, down 11 bp over the last week.

The view in spreads

Implied volatility has now dropped below the average of the last year, easing some of the pressure on spreads. A slowing economy is raising fundamental concerns about credit, although credit still has support from a strong bid from insurers and mutual funds. Bank, mutual fund and foreign demand helping MBS spreads by offsetting the continuing exit of the Fed. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 97 bp, unchanged on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 123 bp, tighter by 10 bp in the last week. Par 30-year MBS TOAS closed Friday at 27 bp, tighter by 5 bp over the last week.

The view in credit

Even though credit has widened lately, the fundamentals still look relatively strong. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Rising unemployment should put pressure on consumers, but high levels of home equity and investment appreciation should buffer the stress. Other parts of the market funded with floating debt continue to show weakness. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. 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 and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly.