The Big Idea

A narrowing gap between MBS and corporate credit

Steven Abrahams | December 6, 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.

In weighing relative value across different parts of US fixed income in the last few years, MBS and consumer credit often seem to have an advantage over corporate alternatives. MBS and consumer assets often will show wider spreads or trade at a wider part of their trailing spread distribution. But parts of corporate credit have routinely topped the market when it comes to total returns, either absolute or risk-adjusted, despite their initial spread disadvantage. The difference may narrow next year but probably not go away.

A snapshot of spread percentiles across sectors

A snapshot of current spread percentiles across key markets should look familiar to anyone doing asset allocation over the last few years (Exhibit 1). MBS and consumer credit trade at wider parts of their trailing spread distribution than corporate credit does. Ginnie Mae 30-year MBS, for example, currently trades at the 66th percentile of its 5-year spread distribution, wider than 66% of Ginnie Mae 30-year MBS spreads in the last five years. Conventional 30-year MBS and ABS trade between the 31st and the 39th percentiles of their distributions. Corporate credit trades much tighter. Investment grade financials trade at the 11th percentile, and the other major parts of investment grade and high yield trade either at the 1st or 2nd percentiles. Over the last few years, these percentiles have changed, but the tendency of MBS and consumer credit to trade wide of corporate credit has not.

Exhibit 1: Percentile rank of current spreads in key parts of US fixed income

Note: Data shows the percentile rank of current OAS in each Bloomberg sector index relative to spreads in the same sector between 12/26/19 and 12/4/2024. The widest spread over that period would have a rank of 100%, the tightest a rank of 0%.
Source: Bloomberg, Santander US Capital Markets.

If every sector traded in some stable range over time, then trading relative value would be straightforward: buy sectors trading at wider percentiles, sell sectors trading at tighter percentiles. If spreads then always reverted to their 5-year median or even reverted to the same percentile across sectors, then the strategy should add to returns—at least for positions in each sector with the same spread duration.

Returns paint a different story

Despite differences in nominal or option-adjusted spreads or in percentiles, realized returns across sectors tells a more complicated story. Over the last five years, the corporate credit exposure offered through leveraged loans and CLOs have typically delivered higher absolute returns with lower volatility than competing assets (Exhibit 2). High yield has delivered relatively high returns, although with relatively high volatility. ABS has delivered modest returns with relatively low volatility. Investment grade corporate debt has provided low absolute returns with high volatility. And MBS has underperformed most sectors.

Exhibit 2: Realized risk and return across selected US fixed income sectors

Note: Annualized daily returns and volatility of returns in Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA Leveraged Loan Return index, and CLOs, which are based on the Palmer Square indices.
Source: Bloomberg, Santander US Capital Markets.

Changing relative returns

Because it is such a large allocation in US fixed income, MBS investors often wonder what might change the relative return trajectory of the sector. Assuming the market continues to price risks consistently across sectors, the likely levers are the usual ones—changes in fundamental risk across MBS and credit or changes in the balance of supply and demand.

On fundamentals, MBS would likely need to see a clear improvement in sector convexity, a significant drop in interest volatility or both to get a lift relative to credit. Credit, on the other hand, would likely need to see a significant rise in defaults or other signals of credit stress, a significant rise in equity volatility or both to start lagging MBS. Although MBS convexity could improve in some scenarios under the next administration in Washington, interest rate volatility is likely to remain high next year. As for credit, most balance sheets look relatively strong, although tariffs under the next administration could hurt corporate valuations broadly and in sectors with significant exposure to trade.

On the balance of supply and demand, MBS could use a systematic return of bank demand and low supply to get a lift. Credit would need a weaker bid from insurers and money managers and a surplus of supply to start to lag. MBS does look likely to get better support from banks in the years ahead than it did from 2022 through 2023, when bank exposure to MBS dropped. It has stabilized this year, although banks remain cautious about taking significant interest rate exposure in MBS. And high mortgage rates have left growth in net supply low. Both of these things help a little. As for credit, the bid from insurers and money managers looks likely to remain relatively strong with many insurers funding demand with heavy issuance of annuities and the market showing an ability this year to absorb impressive supply.

There is a case that the performance difference between corporate credit and MBS could narrow in the year ahead but probably not go away. MBS is likely to get help from stable bank demand and low supply, credit may get tagged a bit by tariffs. But corporate credit fundamentals generally remain strong and demand from core investors steady. MBS is sensitive to the bank bid, which could vary based on opportunities in the lending book. Despite the tight percentiles, corporate credit still looks like it will do well, although perhaps not as well as it has done in the past.

* * *

The view in rates

The market lately has doubted the Fed’s intent to ease in 2025, but a slightly higher unemployment rate in November has dispelled some of that. Fed funds futures continue to move closer to the Fed’s own prediction of the funds rate for the end of 2025, which is below 3.5%. The Fed will come out with a new dot plot on December 18, and many expect the long-term dot to rise. But it still will likely be in the 3% neighborhood. That suggests the current implied pricing of forward rates—the 1-year forward 2-year rate now at 3.98%—-is too high. In addition, heavy Treasury supply next year should at least slow any decline in intermediate and long rates. The curve should consequently steepen more than implied by forward rates.

Other key market levels:

Fed RRP balances have dropped to $130 billion as of Friday. The RRP overnight rate at 4.55% still beats yields on Treasury bills, but not the yield on repo.
Setting on 3-month term SOFR closed Friday at 443 bp, down 6 bp over two weeks.
Further out the curve, the 2-year note traded Friday at 4.10%, down 22 bp in the last two weeks. The 10-year note traded at 4.15%, down 31 bp in the last two weeks.
The Treasury yield curve traded Friday with 2s10s at 5 bp, flatter by 9 bp in the last two weeks. The 5s30s traded Friday at 30 bp, flatter by 2 bp over the same period
Breakeven 10-year inflation traded Friday at 225 bp, down by 9 bp in the last two weeks. The 10-year real rate finished the week at 190 bp, down 22 bp over the last two weeks.

The view in spreads

Implied rate volatility continues to drop after the elections and the November FOMC, and with Treasury supply putting upward pressure on riskless yields, spreads in corporate debt and MBS should generally keep tightening. The Bloomberg US investment grade corporate bond index OAS nevertheless traded this week Friday at 78 bp, wider by 1 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 130 bp, down 1 bp in two weeks. Par 30-year MBS TOAS closed Friday at 34 bp, tighter by 10 bp over the last two weeks.

The view in credit

Fundamentals for consumer and corporate credit still look stable. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties, although a slow Fed pace could delay relief. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Nevertheless, S&P reports rising bankruptcies among the companies it rates, which includes both public companies and private companies with public debt. Unemployment ticked up in November, although high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months.

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

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