Boston - The agency mortgage-backed securities (MBS) market experienced its worst quarter in over 35 years, with the ICE BofA U.S. MBS Index falling 5% in the first quarter. We would have to go back to 1987 and 1994 to find quarters when the index was down more than 2% — not even during the taper tantrum in 2013.
Bond markets wake up to new inflation regime
What happened? For starters, Treasury yields rose anywhere from 54 to 160 basis points (bps), depending on the position along the curve, when the bond market finally woke up to inflation not being as transitory as initially believed. This caused losses in most fixed income sectors.
Our view is that despite the large increase in yields during the first quarter, the bond market may still underestimate the potential for the U.S. economy to be in a new inflation regime. Inflation could be structurally higher than the 2% era we have lived in for the past few decades.
We suspect that investors might have a recency bias when it comes to the Federal Reserve. Aside from 2000, nearly every hiking cycle by the Fed ended at a lower terminal rate than the previous cycle. Based on this recent experience, investors could have expected the Fed's terminal rate this cycle to be below the 2.50% of the last cycle.
That logic may be flawed now, because this is the first time since the early 1990s that inflation is a problem — the Core Consumer Price Index (CPI) is over 6% today. When the Fed was hiking rates from 2015 to 2018 and from 2005 to 2007, inflation was still running around 2%. So comparing this cycle to the last two cycles may not be as relevant.
Inflation stickiness determines bond performance
Why do we mention inflation? In our opinion, the primary determinant of bond performance going forward is whether inflation is perceived to be sticky. While we think inflation may be peaking now, it could stay well above the Fed's 2% target for years to come.
Despite a historic rise to start the year, we feel that Treasury yields have not yet risen to fair value given the inflation backdrop. Unlike last cycle, the Fed may not be hiking for the sake of hiking, but rather to save their credibility.
Agency MBS opportunities in forward-looking markets
How could this inflation and rate-hiking regime impact the agency MBS market? We would remember the wisdom of crowds and that markets are forward looking, often pricing in events long before they happen.
Agency MBS coupon spreads over Treasurys have been widening like clockwork for almost six months straight. As we see it, the primary driver of this spread widening has been the constant readjustment of the agency MBS market to a more aggressive path of quantitative tightening from the Fed.
Over the past few months, the MBS market went from expecting the Fed to purchase MBS in diminishing increments for the rest of 2022 to the Fed shrinking its MBS portfolio by $35 billion by the summer. This is a substantial swing, and in order to adjust, the market took a substantial spread concession.
Agency MBS nominal spreads are now trading roughly 65 bps above their 2021 lows and 35 bps above their 5-year average (red line) — making them one of the few bond market sectors where spreads look attractive on a historical basis.
More than just nominal spreads in agency MBS are elevated. Putting aside a few days in late 2018 and a brief period in 2011, we would have to go back to the end of the global financial crisis in 2009 to find an extended period when agency MBS offered this much yield. The current par coupon — or the coupon rate at which the security's price would be equal to par — is now roughly 280 bps above its low of 2020.
Agency MBS spreads higher even as risk of mortgage prepayment lower
Based on the current yield and mortgage rate environment, investors in agency MBS should actually be getting a lower spread over Treasurys. To understand why, let's review the optionality embedded in mortgages.
Even though agency MBS carry an implicit government guarantee, agency MBS investors collect a spread over Treasurys because the underlying mortgage holders can refinance or move without a prepayment penalty. Because agency MBS investors are essentially short the homeowner's call option to refinance, they get compensated by higher spreads. We say this prepayment risk results in agency MBS having negative convexity.
When mortgage rates are low, many homeowners have an incentive to refinance into lower rates. The option to refinance becomes more valuable, and MBS spreads tend to widen. With the recent rise in mortgage rates above 5%, however, most borrowers are significantly out of the money, making that call option — the ability to refinance — worthless.
Again, agency MBS nominal spreads over Treasurys are quite elevated relative to their 5-year average. In theory, spreads should be widest when a homeowner's incentive to refinance is greatest, and MBS convexity is extremely negative.
But today, spreads are wide at a time when refinancing risk is extremely low. As the majority of the MBS market has swung from trading at a substantial premium over par to a 5-point discount, on average, prepayment risk has plummeted and the convexity of the MBS index is near record highs.
What that means is investors in agency MBS are now receiving higher compensation for a risk that is substantially lower — a nice tailwind for this AAA-rated, government-guaranteed asset class.
Supply from refinancing expected to decline
While the Fed is leaving the MBS market, this is a known event that the market has been repricing over the past few quarters. The backup in mortgage rates to start the year will also dramatically reduce net supply over the coming months, as refinance supply in the market slows to a trickle after being a substantial supplier of bonds last year.
Bottom line: The decline in refinance supply means the private market will have to absorb far fewer bonds than it looked like at the beginning of the year. That makes the Fed's earlier exit less impactful. And after the recent rise in spreads, agency MBS investors can now earn yields that look extremely compelling on a historical basis compared to other high quality parts of the fixed income markets.