By the Centrifuge Credit Group
In our last post, Centrifuge’s Credit Group explored the risks and returns of the US Treasurys market, the world’s largest fixed-income market known for its liquidity and what’s often considered a “risk-free” investment. In this post, we dive into the second-largest fixed-income class – US Mortgage-Backed Securities (MBS).
According to BNP Paribas Asset Management, the MBS market is a significant component of the bond universe, making up approximately 12% of the global bond market and around 23% of the US bond market.
In this post, we provide an overview of this important market and explore the questions to ask when considering allocating to MBS, such as:
- How does the MBS market work?
- What are the key characteristics of this asset class?
- What are the different types of risks to consider when allocating?
- How has this market historically performed?
The MBS market emerged in the 1970s as a way to decouple mortgage lending from mortgage investing. Through the process of securitization, mortgages are packaged and sold as bonds and can be easily traded and held by institutional investors, allowing investors the opportunity to diversify their portfolios beyond traditional Treasurys and corporate bonds.
Securitization today allows these mortgages to be held and traded by investors all over the world. You can read more about the onchain securitization market in the latest Crypto Adoption Curve report.
The MBS market represents the second largest segment of the US bond market and is one of the largest and most liquid global fixed-income markets with more than $12 trillion in outstanding value and over $250 billion in average daily trading volume.
There are two ways to categorize MBS:
- Agency vs Non-agency
Agency MBS carry a government-backed credit guarantee from one of three housing agencies: Fannie Mae, Freddie Mac, or Ginnie Mae.
Fannie Mae and Freddie Mac purchase and securitize “conforming” mortgages, which are typically prime-quality loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs). Although not explicitly government-owned, their debt is perceived to carry an implicit public guarantee, and the two GSEs have been in public conservatorship since 2008. Ginnie Mae guarantees MBS assembled from mortgages explicitly insured by Federal government agencies, primarily the Federal Housing Administration (FHA) and Veterans Affairs (VA).
Non-agency MBS, on the other hand, are issued by private financial institutions and are not guaranteed. Instead, securities are tranched in terms of seniority to cater to investors with different credit risk appetites.
- Residential vs Commercial
The MBS market consisting of mortgages on individual residential properties is called residential mortgage-backed securities (RMBS). There is also an active commercial MBS (CMBS) market secured by a diverse range of commercial real estate (e.g. office, multifamily, industrial, hotel, and warehouse properties). Commercial mortgages are larger, more complex, and more heterogeneous than residential mortgages, and these features are reflected in the design of CMBS.
The chart below shows the relative size comparison between agency RMBS, non-agency RMBS, agency CMBS, and non-agency CMBS:
Source: New York Fed
In contrast to MBS, which are simply securitized pools of mortgages, a key distinguishing feature of agency MBS is that each bond either carries an explicit government credit guarantee or is perceived to carry an implicit one, protecting investors from credit losses in case of defaults on the underlying mortgages.
As we know, the widespread appeal of US Treasurys among global investors can be attributed to the strong backing and the assurance that the US government possesses the capability to fulfill its financial obligations. As the world’s reserve currency, the US government can print additional USD, ensuring its capacity to meet debt obligations.
This kind of safeguarding is also afforded to the agency MBS, explaining why it stands as the world’s second-largest fixed-income asset. The combination of a protected downside and a stable income stream makes agency MBS an attractive investment strategy.
It is important to note that agency MBS funds 70% of U.S. mortgages, which is perhaps why the US government has an incentive to backstop its downside risks.
Since MBS is essentially a securitized mortgage pool and agency MBS a subset, the supply of the asset depends to a large extent on new mortgage origination. The table below shows the profile of various agency MBS pools:
Source: New York Fed
80% of the agency MBS market consists of 30-year fixed-rate mortgages. This new mortgage origination, in turn, is heavily dependent on interest rates. Since the Federal Reserve started its rate hike in 2021, the origination volume of mortgages is down over 60%:
According to Penn Mutual Asset Management, following the Global Financial Crisis (GFC), valuations for the almost $9 trillion agency MBS market have been subject to the demand of two major buyers — the Federal Reserve and US banks — who, combined, currently hold approximately two-thirds of the market.
The Federal Reserve purchased MBS through four rounds of quantitative easing, with the most recent starting in March 2020, in response to the economic disruptions caused by the COVID-19 pandemic. Their holding of MBS shot up to $2.8 trillion in 2022.
In March 2022, however, the Federal Reserve ended quantitative easing and started reducing the size of its MBS holdings in June through passive runoff. They also began raising its policy rate to combat inflation, increasing it from the target range of 0.00-0.25% in March 2022 to 5.25-5.50% in July 2023:
Barclays MBS analysts forecast that the Federal Reserve’s MBS holdings will pay down at an average of just $18 billion a month until December 2024 (if quantitative tightening lasts that long), which will leave the Federal Reserve owning over $2 trillion in agency MBS, even after 30 months of quantitative tightening. If, in the longer run, the Federal Reserve does indeed intend to hold primarily US Treasury securities as stated in its communications, there is still a lot of runoff or even sale to be had. Whether the Federal Reserve will continue running off its agency MBS portfolio will have a noticeable impact on the market.
Banks traditionally invest a portion of their deposits in MBS to earn net interest margin (NIM) – the spread between what they earn from holding MBS and what they pay on deposits. Bank demand for MBS increased in 2020 in response to elevated customer deposits and the Federal Reserve holding rates at zero. As interest rates rose and the yield curve inverted, bank demand for MBS declined:
Looking ahead, the key questions to consider are whether the Federal Reserve will maintain its quantitative tightening approach and if banks will re-enter the market as the yield curve normalizes.
In addition to being the biggest MBS segment, agency MBS is also by far the most liquid:
Source: New York Fed
While the US Treasury market commands the largest daily trading volume, agency MBS commands a huge lead over all other asset classes combined.
Liquidity requires standardization or fungibility. Unlike corporate credit or asset-backed securities where each asset is unique and non-fungible, agency RMBS are interchangeable within its asset class. Instead of fragmenting the liquidity, agency MBS allows liquidity to be aggregated around a single product.
According to a Federal Reserve Bank research paper, over 90% of the agency MBS trades in the TBA (To Be Announced) market. TBAs are forward contracts for the purchase or sale of a specified dollar amount of MBS with a predetermined settlement date and a generic description of the securities to be delivered.
The seller of the TBA agrees on a sale price, although they do not specify which particular mortgage pools will be delivered to the buyer on settlement day. Only a few basic characteristics of the pool are agreed upon, such as the issuer, maturity, coupon rate and face value.
The TBA market is based on the fundamental assumption that one agency MBS pool can be considered interchangeable with another pool possessing similar characteristics. The seller has control over the delivery and will seek to select the “cheapest to deliver” securities. The buyer anticipates “adverse selection” in exchange for the liquidity of the TBA transaction.
These trading conventions enable an extremely heterogeneous market of multiple agency MBS pools to be distilled into standardized TBA contracts, which supports the liquidity profile of MBS pools, making the TBA market is one of the most liquid fixed-income markets in the world.
The agency MBS market benefits from the implicit back-stop guarantee of the US government, minimizing its credit risk to that of the US Treasury market. While an agency MBS usually offers a yield premium compared to Treasurys, this compensates investors for taking on the prepayment risk associated with the underlying mortgages. Investors receive compensation for the uncertainty of “when” they receive the bond’s principal, but not “if.”
The key risks associated with agency MBS are:
- Spread Volatility
Similar to any non-government fixed-income security, agency MBS valuations are subject to changes in spreads. If spreads widen, the prices of agency MBS will decline. If spreads tighten, the prices of agency MBS will increase. Given the unprecedented volatility in the rates market following the Federal Reserve’s quantitative tightening and rate hikes, the spread on MBS has widened to historical highs, reducing its returns.
- Prepayment/Negative Convexity
When homeowners pay back more principal than required by the regular amortization schedule, it is considered a prepayment. This may occur for several reasons. For example, the homeowner might refinance into a mortgage with a lower rate, experience a life-changing event (relocation for a new job, divorce or death) or move into a new home. Because the principal is being returned to the investor at par, this can detract from returns if the mortgage-backed security was purchased at a premium price. This means that, unlike US Treasurys and Investment Grade (IG) credits that appreciate when the rates fall, MBS lose value as homeowners refinance into lower rates. In other words, MBS exhibits negative convexity.
The chart below shows the spread premium on current coupon MBS vs 5/10 yr US Treasury blend and IG credit:
On an absolute basis, the current coupon MBS spread over similar tenor US Treasurys is close to historical highs at 170 bps. Even when compared to the excess spread offered by IG credit, current coupon MBS commands an additional premium of close to 50bps.
If the economy goes into a recession and the market takes on a risk-off nature, agency MBS may be better positioned to receive support from the Federal Reserve than IG credit (after all, the Federal Reserve was a key buyer of agency MBS during its quantitative easing phase).
Source: Western Asset
According to the famed credit investor, DoubleLine, there have been six recessions since 1976 and total returns have been positive for agency MBS 12 months following each one. Apart from the 2020 recession, agency MBS have outperformed IG credit five out of the six times.
Using iShares MBS ETF as an illustrative example, if an investor was looking to allocate to the agency MBS sector, here is how iShares MBS ETF performed vs other high-quality fixed-income assets in the past:
Source: iShares website
Using the same ETFs’ benchmarks, the return per unit of risk is as follows:
The last column shows the upside per 1% standard deviation risk of an asset class. This provides a way to think about how these different assets stack up against one another when adjusted for their return dispersion. By this measure, the short-term US Treasury ETF looks the most attractive and the MBS the third most.
This is just one way of measuring and comparing these quality fixed-income assets. The actual allocation decisions need to be preceded by a well-thought-out investment objective. For example, if an investor wants to target an annualized yield of 7% over a 10-year period and believes the interest rate and inflation will both be below 2% soon, then perhaps the 20-Year Treasury Bond ETF with its longer duration and higher total return will be a more suitable option.
For investors, it’s crucial to grasp the performance dynamics of each asset within a fixed-income portfolio. Understanding how different assets align with specific economic assumptions is key to determining the most suitable combination for achieving one’s investment objectives.
In summary, the MBS market, especially agency MBS, plays a vital role in the US financial system, backed by the implicit credit guarantee of the US government. With a $12 trillion valuation, it provides a unique risk-return profile similar to US Treasurys. The notable reduction in MBS holdings by both banks and the Federal Reserve in 2023 raises questions about its future dynamics.
While the Federal Reserve plans to continue passive balance sheet runoff in 2024, the banks’ actions are more economically driven. The interplay between the Federal Reserve’s interest rate decisions and bank demand for MBS is a key factor to watch for, particularly concerning yield curve dynamics.
The current close-to-historical spread prompts consideration for entering the MBS market, but the crucial question is how much of a portfolio should be allocated to this asset class. BlackRock suggests that agency MBS can diversify portfolios with investment-grade credit and serve as a hedge against high US Treasury exposure. Ultimately, the decision rests with investors based on their assumptions and investment objectives.
Want more Asset Primer Overviews? Read our last post on US Treasurys.
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