Mortgage-backed securities (MBS) are often overlooked as a source of long-duration exposure in corporate defined benefit plan portfolios, where
long government and long credit bonds typically dominate. Yet agency MBS offer one of the highest long-term information ratios relative to U.S.
Treasuries and the lowest correlation of excess returns to the S&P 500 Index, as we detailed in “The Unique Benefits of Mortgage-Backed Securities.” In this Q&A, we discuss how a portion of the MBS market is an attractive fit for
Q: Long corporate bonds would seem to be natural hedging assets in a liability-driven investing (LDI) portfolio because they are used to calculate the
discount rate for pension liabilities. How do MBS work in this context?
A key tenet of PIMCO’s approach to LDI is that active management and diversification in the fixed income strategy are critical to long-term success.
Long-duration MBS can help to diversify an LDI portfolio away from traditional government and corporate bonds, agencies and municipals. This can be done
either as a tactical exposure within a broad LDI mandate or as a stand-alone strategy – and in ways that optimize asset-liability matching. From a risk
perspective, we view long-duration MBS as a step outside of traditional U.S. government bonds, but one that avoids the credit risk of long-duration
Q: Long-dated liabilities have high positive convexity while agency MBS are negatively convex instruments. How can they play a role in long-duration
fixed income portfolios designed to hedge pension plan liabilities?
In general, the agency MBS sector has shorter duration (approximately three years currently) and greater cash flow uncertainty than traditional
long-duration government-related or credit investments. This is due to the prepayment optionality that U.S. mortgage borrowers possess on standard fixed
rate mortgage loans, the majority of which are 30-year mortgages. When interest rates decline, borrowers refinance their mortgages to obtain lower interest
rates; when rates rise, they tend to pay down mortgages with less urgency.
However, the process of structuring agency MBS cash flows creates a series of collateralized mortgage obligations (CMOs). Instead of tranching credit risk,
where bonds are created with varying degrees of credit risk, agency CMOs tranche prepayment risks, creating classes with varying degrees of exposure to
changes in interest rates, the shape of the yield curve and prepayment speeds on underlying mortgage loans. This can dramatically change the cash flow
stability and convexity of MBS. Active management can play a further role in identifying security structures and collateral characteristics best suited for
Figure 1 shows how cash flow structuring of a 4% MBS guaranteed by Fannie Mae with a yield of approximately 2% and a weighted average life of 3.7 years can
create two securities – a shorter, lower-yielding security and a longer-duration, higher-yielding security. Essentially, this creates a 12-year bond with a
yield of 3.2% by limiting the potential extension risk of the three-year bond which yields 1.4%. The shorter bond at the front end of the structure absorbs
the majority of initial prepayments, providing a locked-out period where the longer bond is insulated from prepayment risk. While duration- sensitive
investors may seek to purchase the shorter bond, the longer-duration bond with superior convexity creates an additional tool in the long-duration toolkit
for liability-hedging plan sponsors.
Q: How should investors think about an allocation to long-duration agency MBS?
At PIMCO, we typically advise clients to allow portfolio managers as much flexibility as possible in meeting client’s risk/return objectives.
We believe that long-duration agency MBS work best as part of a broader long-duration portfolio, which presumably focuses on long-duration government bonds
and/or long corporate credit.
Historically, the role of long government bonds in LDI has been to diversify the long credit component of the fixed income portfolio and/or equity exposure
at an overall asset allocation level. In essence, this is a barbell approach to diversification, with government bonds and corporate bonds at opposite ends
of the credit risk spectrum. Yet, although diversification benefits are susceptible to changes in correlations, a barbell approach can magnify risks.
A more balanced approach would prudently allocate long-duration CMO exposure across a broader long-duration portfolio. For example, long-duration MBS can
be used to gain additional spread relative to long-duration U.S. Treasuries, while maintaining a high-quality bias with little corporate credit risk.
Instead of earning compensation for incurring credit risk in long-duration credit, investors are paid for the cash flow uncertainty associated with
prepayment risk in agency MBS.
As Figure 2 shows, yields of long-duration MBS are greater than the Long Government Index, with less duration. Long-duration MBS yields are significantly
lower relative to long credit, especially given the recent cheapening in corporate credit risk. Importantly, as of 29 February, the correlation of long MBS
to long government bonds was 0.75, while the correlation to long credit was just 0.59. However, while long-duration MBS are U.S.
government/agency-guaranteed, they carry spread duration; in risk-off, flight-to-quality rallies in interest rates, MBS spreads can widen materially,
resulting in mark-to-market volatility on long-duration MBS relative to long-duration U.S. Treasuries.
We take this dynamic into account in scaling long-duration MBS exposures in portfolios. In full-discretion portfolios, we typically allocate up to 10%
after careful analysis of the trade-offs between enhanced return potential and tracking error relative to liabilities. Understanding how and when to scale
exposure to this asset class can potentially mitigate the overall convexity risk of a portfolio.
Q: High-quality corporate bonds are often limited in supply. What’s the size of the market for long-duration CMOs?
PIMCO estimates the agency CMO universe to be approximately $885 billion, about 9% of which has durations longer than seven years. While CMO issuance has
slowed, over the past 12 months just over $150 billion was issued, 12% of which had durations greater than seven years. Therefore, while the long-duration
CMO market is relatively small, it still provides ample opportunity for long-duration investors.
Q: What are the risks in a long-duration MBS portfolio?
Outside of the standard concern of the mark-to-market volatility associated with a sharp rise in interest rates, other important risks include:
Government-guaranteed, long-duration MBS do not trade with nearly the same bid/ask spreads or daily trading volume as long-duration U.S. Treasury or agency
bonds. This can create unexpected volatility, as was witnessed in 2008 when agency MBS spreads widened to 300 basis points (bps) above U.S. Treasuries.
While the sector held up significantly better than investment grade corporates (where spreads exceeded 500 bps), it is an important example of agency MBS
not always serving as a “hard” duration asset. The sector can be prone to material dislocations in liquidity, especially as it relates to CMOs.
Long CMOs can provide significantly more cash flow stability/prepayment protection than a traditional agency MBS pass-through, but only to a degree. When
prepayment speeds increase significantly and for an extended period, bonds with payment priority ahead of the long CMOs may amortize faster than expected,
resulting in a declining cash flow buffer to protect the long CMO from increasing prepayment speeds. Over time, this can result in a major shortening of
the long CMO cash flow, creating mismatches for liability-driven investors.
Given that the sector’s liquidity can be fragile and scaling can be challenging, we believe long
CMOs are most useful as an off-benchmark allocation in a broader long-duration government/credit portfolio. Furthermore, if investors are seeking
stand-alone, long-duration MBS strategies, a strong understanding of both prepayment risk and cash flow structuring is critical to long-term success.
Q: Would adding MBS to an LDI allocation increase risk relative to liabilities?
Because pension liabilities are discounted with a high-quality AA corporate rate, any allocation outside of that universe would theoretically increase
risk/tracking error. Nonetheless, there are many practical issues to consider in broadening the LDI opportunity set with long-duration MBS:
First, liability discount curves were not intended for investing but as a proxy for valuing a pension plan’s liability for accounting or funding purposes.
Much has been written about this topic, but the long AA corporate bond universe is generally uninvestable in isolation given severe concentration risk –
the top five issuers represent 60% of the index, and supply of bonds in this segment is waning. Additionally, there are many flavors of the AA discount
curve with various constraints, provider exclusion rules and spline/curve fitting methodologies, rendering it an abstract representation of
liability-matching investments. This argues for improved diversification in an LDI portfolio with a broadened credit universe that includes the full
investment grade set of bonds and potentially other fixed income securities such as government bonds and long-duration MBS.
Second, while an LDI portfolio dominated by credit investments can face potential defaults (albeit a rarity in the investment grade space) and downgrades,
liabilities cannot default or be devalued due to downgrades; i.e., the plan sponsor is obligated to provide the promised benefits to their plan
participants. Thus, we suggest reducing single-name concentration as much as possible, with the constraint that the diversifying asset is not meaningfully
under-yielding a duration-equivalent long corporate bond. Given the potential diversification benefit and yield trade-off shown in Figure 2, long-dated
mortgages would be preferred over Treasuries to some extent.
Third, stepping back and looking at the broader pension asset allocation, it is important to consider overall asset-liability risk, or more specifically,
the drivers of funding-ratio volatility. In a majority of plans, equity allocations still dominate and contribute meaningfully to this risk. The
composition of the liability-hedging allocation also affects overall risk, and having a marginal allocation to long-dated MBS may improve diversification
at the overall plan level, which in turn would help reduce funding-ratio volatility.
Q: How should a plan sponsor think about implementing a long-duration MBS strategy?
Mortgages would typically be characterized as out-of-benchmark exposures relative to the traditional liability-hedging benchmarks. But they can also be
included in two additional ways: 1) as a structurally defined component of the LDI benchmark – for example, 70% long corporate/15% long government/15%
long-dated CMO or 2) as a stand-alone strategy, albeit with two important considerations:
- Are long-duration MBS cheap relative to other long-duration assets?
- Are there diversification benefits to owning long-duration MBS?
Crucially, if investors are seeking stand-alone long-duration MBS strategies, a strong understanding of both prepayment risk and cash flow structuring is
critical to long-term success.
Q: How would PIMCO design a stand-alone, long-dated MBS portfolio?
PIMCO’s approach to long-duration MBS strategies is predicated on security selection and diversification. Our focus is on well-structured bonds that we
believe have the ability to withstand changes in prepayment speeds. In addition, collateral selection can help to mitigate the risk of negative convexity.
To this end, we emphasize the identification of collateral attributes that provide cash flow stability and, equally important, finding attractive entry
points to buy these collateral attributes. Examples would be bonds backed by lower loan balance collateral, where borrowers lack the incentive to refinance
even if interest rates were to decline, as the monthly savings on a lower loan balance mortgage are limited.
In addition, select use of agency pass-throughs, longer-dated agency and potentially non-agency collateralized CMBS and even relative-value overlay
strategies can expand the opportunity set in a long-duration MBS portfolio. Ultimately, portfolio construction would depend on the level of discretion and
ultimate goal of the portfolio (total return versus liability-matching substitute).