When the QE music stops, US MBS will still be dancing

14 Jun 2018

When leading central banks stop playing the monetary policy tunes that many financial markets have been dancing to over the past decade – that jaunty ditty called quantitative easing, or QE as it is known by its abbreviation – the financial assets that were the winners under QE look set to become the losers, but there is one asset class that should continue to hum along nicely: US mortgage-backed securities (MBS), as fund manager John Carey explains.


Tables turned: MBS and QE

As QE sought to lower and keep down interest rates – in a bid to spur economic growth and rekindle inflation – it centred on large markets in fixed-income instruments, and in particular on US government bonds (Treasuries) and MBS.

Under its QE programme, the Federal Reserve (Fed) bought Treasuries and MBS on a large scale, becoming a dominant force in these markets and crowding out other investors. Investors thus had to turn to riskier sectors, driving up demand – and with it, prices and total returns, resulting in a bonanza for sectors including investment-grade and high-yield corporate bonds.

With US economic growth and inflation now well entrenched in recovery territory, the Fed has called quits on QE, begun raising its policy rate gradually and is in the process of equally gradually offloading many of the assets it accumulated on its books under the QE programme.

That raises the question: what is next for MBS and what could be reasons for investors to hold on to, or buy, agency MBS?


What is next for MBS

While other bond categories typically suffer when interest rates rise, forcing yields up and concurrently prices down, agency MBS has historically held up well. Its high quality is one reason. Securities in the agency MBS sector have an implicit or explicit US government guarantee and therefore the same AAA credit rating as US Treasury bonds. The quality is also underscored by the total absence of defaults to investors in the agency MBS market in its entire history.

But, hang on, these securities are backed by mortgages and there is a risk that mortgages are refinanced and paid down (‘prepaid’, in MBS jargon) before they mature when interest rates move, right? Quite so, but that risk is typically largest when rates fall and mortgage holders want to lock in cheaper mortgage rates. This is not the case now.

Exhibit 2:  Refinancing activity: historically strongly linked to 10-year yields


Source: Bloomberg, as of 3 June 2018

And what about potential home buyers and mortgagors who held out in recent years on signing a mortgage or refinancing as rates fell and home buyers, betting that rates could go lower still and hoping to get in at the bottom? Now that the rate cycle has reversed, they have indeed come off the fence and burst into action.

This helped to undermine the historically strong correlation between refinancing and yields earlier in the year. Recently, refinance rates dropped to their lowest levels since 2000.  We are now in a phase of limited refinancing supply and thus limited prepayment risk.

Undeniably, prepayment risk is part and parcel of MBS, but it is worth noting that investors are compensated for it in the form of a yield premium over US Treasuries.


Reasons for investors to hold on to, or buy, mortgage-backed securities

Next to resilience in a climate of rising interest rates, MBS boasts other confidence-inspiring features.

The agency MBS market is the second largest bond market in the world behind the US Treasury market. Market liquidity is high: in excess of USD 200 billion of agency MBS is traded every single day. In the non-agency sector, markets only trade about USD 3 billion per day.

Exhibit 2: US Agency MBS : average daily trading volume


Source: SIFMA, data as of 31 December 2017

Additionally, mortgage investors can take advantage of higher yields faster than investors in other fixed-income sectors. Agency MBS offers investors monthly cash flows from principal and interest payments, whereas Treasury and corporate fixed-income securities only have semi-annual coupons and only return the principal at maturity. The MBS sector thus provides investors with the opportunity to reinvest cash flows in the currently higher market yields more frequently.

Finally, agency MBS offers investors diversification benefits: performance is de-correlated from that of other components of a fixed-income portfolio such as corporate bonds. So investors seeking to diversify their exposure and able to spot inefficiencies in the agency MBS market stand to earn a diversifying return stream with low correlations to credit markets. How sweet the sound!