Agency mortgage-backed securities (MBS) were well supported in 2017 despite some concerns around the US Federal Reserve’s (Fed) intention to normalise its balance sheet and tight valuations. Looking ahead we explain why we believe the asset class will continue to be supported from a fundamental standpoint in 2018 and our view on the likely impact of the Fed’s announcement over the longer term.
During 2017, the agency MBS sector witnessed significant swings in investor sentiment as the Fed began signalling its intentions to normalise its balance sheet.
When the Fed announced details of a gradual and predictable tapering of reinvestment purchases in June 2017, that, coupled with tight spread valuations in credit markets, led to a renewed investor focus on agency MBS.
Despite this concern, the yield of agency MBS investments was supported during 2017 as fundamentally mortgage rates remained stable between 4.0% and 4.5%. This resulted in a dwindling of borrowers’ refinancing activity and prepayment risk remained benign.
This month’s insights focuses on the outlook for 2018 for the asset class and considers the fundamental and technical aspects of the market
When investing in agency MBS, prepayment risk is a key consideration as US mortgage borrowers can repay their loan in full or part at any time without penalties. Changes in mortgage rates can drive the prepayment behaviour of borrowers, as when mortgage rates fall, borrowers are more likely to prepay their loan early and avail of the lower mortgage rate on offer.
Current mortgage rates are ~4% in the US. A move by mortgage rates to below 3.5% would likely significantly increase refinancing activity but absent a recession, our economic views do not support such a move lower in rates for a sustainable period of time. Should rates move higher, prepayment risk would decrease, but mortgage durations would initially extend (as loans remain outstanding for longer than originally anticipated).
However, the extension potential from the current agency MBS duration of 4.5 years is limited in the historical context of recent years as illustrated below.
Agency MBS duration
Source: Bloomberg Barclays indices as of Sept. 29, 2017
Given this backdrop, we believe the fundamental outlook for agency MBS for 2018 is likely to continue to be supported.
Supply and demand technicals are balanced in our view. Over the near term, housing purchase activity typically slows during the winter months in the US, which should reduce issuance. Fed reinvestment purchases will shrink to $US15 billion from $US20 billion a month, which, coupled with residual bank and real estate investment trust (REIT) demand, should keep spreads stable. Assuming US residential lending standards remain conservative, 2018 issuance could look similar to the pace of the past two years.
Regarding the Fed’s balance sheet normalisation, we expect the ebb and flow of reinvestment amounts of agency MBS and Treasuries to lead to relative performance differences. In the first half of 2018, when the Fed’s Treasury maturities increase sharply, Treasury reinvestments are expected to surpass agency MBS.
Agency MBS – Treasury re-investment
Source: Federal Reserve and J.P. Morgan as at September 2017
At that point, we would expect investors to step in if agency MBS spreads widen. While the relative value consideration may vary amongst money managers (as they try to beat their respective benchmarks within their investment guideline constraints) making their behaviour more difficult to predict, the outlook for banks is likely to be shaped by lower excess reserves, capital and liquidity regulatory constraints, and net interest margins. As excess reserves continue to shrink, banks will need high-quality assets such as Treasuries and agency MBS to maintain liquidity coverage ratios. Higher agency MBS holdings relative to Treasuries also support net interest margins.
Over the medium to long term, we expect the balance sheet runoff to be marginally negative, but we are less focused on its impact relative to net issuance, as the Fed is not actively selling securities but gradually reinvesting less. We view the stock effect as more relevant, and expect the Fed’s balance sheet to include agency MBS. If the normalisation process occurs in line with the current Fed guidance, we anticipate that the Fed’s agency MBS holdings would gradually shrink from the current 26% of the market to approximately 20% over the next five years, which could cause spreads to widen by ~10–20 basis points over this timeframe.
Our current outlook for agency MBS can be summarised as fundamentally positive and technically balanced. This is coupled with valuations looking full and volatility likely to increase in 2018 as central banks continue to withdraw stimulus.
Given this backdrop the Macquarie Absolute Return Mortgage-Backed Securities Strategy continues to diversify prepayment risk, avoid the intermediate coupons targeted by Fed purchases and maintains exposure to the flattening yield curve trend. In addition, a barbell strategy is employed using a combination of high coupons seasoned pass-throughs and low coupon long duration agency Collateralised Mortgage Obligations (CMOs) and Interest Only CMOs to maximise yield.
We continue to believe that when combined with an investment process focused on fundamental research and capital preservation, Agency MBS offer a structurally attractive risk/reward profile to an absolute return strategy.