Agency MBS: A Strategic Allocation

Text on screen: Agency MBS: A Strategic Allocation

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Text on screen: Dan Hyman, Portfolio Manager, Agency Mortgages

Agency mortgage-backed securities are bonds backed by U.S. mortgage loans and carrying a guarantee from one of the U.S. agencies, Fannie Mae, Freddie Mac or Ginnie Mae. They are an exceptionally liquid product and have historically provided an excess return over treasuries across the full business cycle.

Today, agency mortgage bonds are trading at attractive relative spreads to investment grade credit bonds. In normal markets, agency MBS have a lower spread over treasuries than corporate bonds because corporate bonds carry credit risk.

So why are agency mortgages trading so wide in today's market? In short, it's because the excess supply within the agency mortgage market. The excess supply is coming from two primary sources.

First, the Fed. The Fed is engaged in quantitative tightening or QT, allowing their balance sheet to run off, creating about 15 to 20 billion bonds of extra supply per month. The second reason is the U.S. banking sector has not been purchasing as many mortgages, as their deposits declined in 2022 and ‘23. With these two large buyers of agency mortgages absent from the market, spreads have widened without a natural buyer to take their place.

So what will bring agency mortgage spreads back to normalized levels? Well, the Fed is unlikely to come back to the agency mortgage market, but they're shrinking their balance sheet each year and the negative impact of QT declines with time.

While bank buying has been below historic trends, we expect it to be a net positive in 2025. While we expect spreads to tighten in agency MBS over time, with elevated current yields and wide spreads, we are earning an attractive yield while we wait for these spreads to normalize. We have invested heavily in agency mortgages, both in dedicated mandates and across our multi-sector fixed income portfolios.

This has allowed portfolios to both increase the credit quality and the yield, and become more defensive without having to sacrifice yield.

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Disclosure

This material contains the current opinions of the manager and such opinions are subject to change without notice.  This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.

All investments contain risk and may lose value.

Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations.

U.S. agency mortgage-backed securities issued by Ginnie Mae (GNMA) are backed by the full faith and credit of the United States government. Securities issued by Freddie Mac (FHLMC) and Fannie Mae (FNMA) provide an agency guarantee of timely repayment of principal and interest but are not backed by the full faith and credit of the U.S. government.

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