This article originally appeared on
institutionalinvestor.com on 19 September 2015.
Here’s a multifaceted objective that we have heard from investors over the years, one that is particularly topical considering recent market
volatility: How to outperform U.S. Treasuries without drastically increasing the correlation of fixed income holdings to equities, while maintaining a
high degree of liquidity.
While only death and taxes are certain, taking a closer look at securities backed by mortgages uncovers some appealing characteristics.
Mortgage-backed securities, or MBS as they are commonly known, have generally tended to offer a high degree of liquidity, a high historical Sharpe ratio
and low correlation to risk assets. Moreover, their complexities can create market dislocations, making them a particularly ripe source of potential
alpha-generating opportunities for active managers.
While MBS rarely take center stage during investor conversations regarding asset allocation, we believe that a strong understanding of the merits of MBS is
important, as the sector can be a useful ingredient in a high quality fixed income allocation. After all, the U.S. residential and commercial MBS markets
exceed $7 trillion and make up about 30% of the Barclays U.S. Aggregate Bond Index and 12% of the Barclays Global Aggregate Index, according to the
Securities Industry and Financial Markets Association and Barclays, respectively, as of 30 June 2015. The largest and most liquid component of MBS exposure
in the Barclays Aggregate is mortgage bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. There also are sizeable private label residential and
commercial MBS markets.
Importantly, agency MBS valuations are not cheap at current levels, and these securities are accompanied by both interest rate and prepayment risk. Prices
have been inflated by accommodative policies of the Federal Reserve, which owns over $1.75 trillion in agency MBS. However, agency MBS have cheapened
year-to-date – and the prospect of less Federal Reserve accommodation and higher interest rate volatility may create the potential for better entry points.
In our view, investors should consider four historical benefits provided by agency MBS:
High historical Sharpe ratio
– The agency MBS sector has provided among the most consistent sources of risk-adjusted returns relative to like-duration U.S. Treasuries of any fixed
income asset class. More recently, massive central bank accommodation and global demand for yield have resulted in outsize risk-adjusted returns in many
credit sectors. However, the agency MBS Sharpe ratio has remained consistent over time.
Volatility sales have often been a primary driver of this phenomenon. Given that the typical U.S. 30-year mortgage loan can be prepaid at any time, the MBS
investor (the lender) is short a call option to the borrower to prepay (or call) their mortgage at their discretion. The resulting risk profile is a long
position in a government-guaranteed bond and a short position in a call option. Being short an option creates the exposure to volatility. As Figure 1
shows, investors have earned attractive compensation for incurring this risk over the long term.
Low correlation to risk assets
– Excess returns from agency MBS have had among the lowest correlation to risk assets of any fixed income sector (see Figure 2). Unlike many other spread
sectors, relative to like-duration U.S. Treasuries the primary risk factor in agency MBS is prepayment risk rather than exposure to credit fundamentals
and/or bond market liquidity. Even within the credit component of the MBS market, private label commercial mortgage-backed securities (CMBS) have had a
lower correlation to equities than corporate and emerging market debt.
This is a key feature of the agency MBS market, as many bond market investors seek to diversify their overall portfolios. The tendency for agency MBS to
achieve this goal is unique in global fixed income markets, especially when compared with corporate credit or emerging market debt, where correlations of
excess returns to equities are historically in the 0.6 to 0.7+ range.
– Liquidity is another key distinguishing factor of the agency MBS sector, especially in an environment where regulation has reduced the role of
intermediaries and negatively affected liquidity across many credit sectors. Diminished liquidity can result in wider bid/ask spreads and more fragility
during periods of market dislocation. While liquidity in agency MBS may be weaker than historical levels, on average the sector continues to trade more
than $200 billion per day (see Figure 3), according to the Securities Industry and Financial Markets Association, and with minimal bid-ask spreads relative
to many other credit sectors.
This allows for active relative value trading within the sector, in an environment where the beta of agency MBS may be less attractive than historical
norms. Long/short trading within the agency MBS market has the potential to be an attractive, liquid alpha source, especially in the current environment.
Active management opportunities
– In addition to the attractive characteristics that may be provided by simply owning the beta of MBS, the complexity of the mortgage market has
facilitated consistent, excess return potential. Prepayment risks are intricate, and sophisticated MBS investors often disagree materially on the value of
embedded call options. In addition, given the large footprint of investors not driven by total return goals, the agency MBS market is constantly dislocated
and mispriced. This can result in frequent, attractive and liquid opportunities for active managers to extract additional risk-adjusted returns above and
beyond what passive exposure to the sector has historically provided. In private label mortgage markets, differences in collateral and security structures,
among several other factors, may provide further opportunities for excess returns.
At home with MBS
The MBS market offers the potential for investors to outperform U.S. Treasuries without drastically increasing the correlation of their fixed income
holdings to their equity exposure, while still maintaining a high degree of liquidity. The agency MBS sector historically has demonstrated a tendency to
successfully address these goals, while also providing attractive opportunities for active managers to generate excess returns. This may be especially so
as we enter a period of less accommodative Federal Reserve policy and higher interest rate volatility.