Agency mortgage-backed securities (MBS) strategies have faced difficulties in recent months as uncertainty over the Fed’s tapering policies induced interest rate volatility, depressed MBS prices and prompted some investors to reduce their MBS exposure. This fluid environment, however, has underscored the value of the unique and unconstrained approach of PIMCO’s Mortgage Opportunities Strategy. Its ability to go beyond traditional MBS benchmarks and diversify risk through active management is likely to remain an advantage as the Federal Reserve prepares to withdraw monetary stimulus and eventually guide rates higher.
Few markets have been as directly impacted by Fed policies as the MBS market. Since taking aim at the housing market at the depth of the financial crisis, the Fed has purchased a total of more than $2.4 trillion of MBS guaranteed by Fannie Mae (FNMA), Freddie Mac (FHLMC) and Ginnie Mae (GNMA). Although these securities provide a liquid source of government-backed credit spread, recent concerns over a “taper on,” “taper off” of stimulus have stoked volatility and prompted some investors to reduce exposure to the asset class (see Figure 1).
While the Agency MBS market – comprising residential MBS guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae – is the largest component of the securitized mortgage market, it is only slightly more than half of the entire securitized market. As a result, traditional bond benchmarks do not reflect the entire mortgage universe (see Figure 2). Securitized products represent 32% of the Barclays U.S. Aggregate Index, nearly all of them plain-vanilla Agency MBS (93%). Thus, traditional MBS strategies focused on the mortgage market are managed against indexes composed of Agency MBS, and in many cases, only GNMA MBS. The result is that the majority of mortgage exposure in traditional fixed income strategies is composed of traditional Agency MBS. While these high-credit-quality instruments can serve as useful tools, offering excess spread over Treasuries for a similar credit, and opportunities for excess returns from relative value, their primary risk is interest rate risk, an exposure that many investors are looking to reduce in the current environment.
A more flexible, diversified approach to investing in mortgage markets
PIMCO’s Mortgage Opportunities Strategy is benchmarked against the 3-month Libor Index, not traditional mortgage benchmarks. It therefore has greater flexibility to pursue a diversified, absolute-return-oriented strategy combining both interest rate exposure and credit-sensitive MBS across residential and commercial mortgage markets in the U.S. and Europe.
Here are several recent tactics aimed at navigating the market’s volatility:
1. Relying less on bond market beta. Tactical relative value trades seek to extract value from the Agency MBS market with limited beta exposure. Specifically, the PIMCO Mortgage Opportunities Strategy has sought to capitalize on dislocations in relative value between Agency MBS and U.S. Treasuries by shorting Agency MBS and going long U.S. Treasuries with equal duration, or vice versa, as valuations dictate. This approach has the potential to generate uncorrelated absolute returns without having to take directional positions on interest rates. In an environment with less compelling bond market betas, tactical relative value trading may add returns to flexible bond portfolios while limiting interest rate exposure.
2. Using carry and roll down to position for low short-term rates for an extended period of time. At PIMCO, we often talk about carry and roll down. In its simplest form, roll down is the concept of a 5-year bond becoming a 4-year bond 12 months from now, which implies coupon plus price appreciation of the security if interest rates remain unchanged. However, as tapering speculation took center stage during the late spring and summer months, forward expectations of interest rates increased dramatically, essentially implying that roll down will be less attractive going forward. However, we think this is unlikely: To occur, we would need to be entering a period of growth that would create more than 300,000 jobs per month for at least one year. One of PIMCO’s highest-conviction investment themes is that future interest rates implied by current market pricing will not be realized – resulting in meaningful roll-down opportunities.
In the PIMCO Mortgage Opportunities Strategy, we have focused on adding exposure to structured Agency MBS with coupons that benefit from the fed funds rate remaining lower, and for longer, than the market-implied pricing. Inverse interest-only bonds, unique to the mortgage market, provide an efficient instrument to roll down the yield curve while providing higher yields than traditional Agency MBS in the interim, as long as short-term rates remain low. These bonds are sensitive to changes in interest rates (and prepayments), but most of the interest rate sensitivity is focused on the very front end of the yield curve. Given PIMCO’s view that short-term interest rates will remain low until at least 2016, we believe the Strategy is well insulated from eventual tapering.
3. Focusing on the green shoots of a housing recovery. Legacy non-Agency MBS continue to provide attractive return potential with additional upside in the event housing prices exceed market expectations. Since the financial crisis, 93% of the non-Agency MBS originally rated AAA has been downgraded to below investment grade. While the ratings may not be attractive, the risk/reward profiles of these bonds can be. Many legacy non-Agency MBS continue to trade well below par, providing 6% to 8% loss-adjusted yields in PIMCO’s base-case housing scenarios and further upside if home prices rally further. With low levels of new construction, elevated affordability and strong demand from investors, PIMCO expects nationwide housing prices to rise by 5% to 10% over the next two years.
Managing the risks of tomorrow’s interest rates
Each day, we are one day closer to the Federal Reserve reducing its purchases of Agency MBS, a development that will surely create more uncertainty in long-term interest rates. Thus, we believe a mortgage strategy that is not focused on interest-rate-sensitive Agency pass-throughs can help investors bridge the gap between today’s level of interest rates and higher long-term interest rates without sacrificing returns. More conservative, traditional Agency MBS strategies still serve a purpose in an investor’s portfolio by providing high-credit-quality spread to U.S. Treasuries. However, a more flexible mortgage mandate that incorporates long and short strategies in Agency MBS, while also investing in credit-sensitive MBS backed by both residential and commercial mortgage loans, can diversify risk factors and adapt to an evolving opportunity set in securitized mortgages.