20 Jul 2022
Fixed Income Navigator
July 11, 2022 | 7 Minute Read
Three key obstacles have challenged performance in the agency mortgage-backed security (MBS) market year-to-date (YTD): an accelerated timeline for tighter US Federal Reserve (Fed) quantitative tightening (QT), negative technical dynamics and stubbornly high interest rate volatility.
We have transitioned from an underweight to overweight position in agency MBS as we believe higher yields and spreads have created a carry cushion for lingering headwinds. In addition, the sector’s convexity profile has improved at the index level. Finally, low beta of agency MBS makes it an attractive asset class in an environment of decelerating—though still positive—economic growth.
Within the sector, we favor higher coupon mortgages that are less exposed to the Fed’s balance sheet unwind and Ginnie Mae mortgages given more attractive valuations relative to conventional mortgages and a positive demand tailwind from domestic banks.
Deconstructing Underperformance
The agency MBS market has experienced sharply negative total returns year to date (Exhibit 1).
Exhibit 1: Sharp weakness over the past year
Source: ICE BofAML. As of June 30, 2022. Past performance does not guarantee future results, which may vary.
Three key factors have fueled the underperformance:
An expedited tightening timeline. The primary trigger for weakness in agency MBS this year has been an accelerated timeline for Fed rate hikes and balance sheet normalization—or QT—in response to elevated inflation. At the May Federal Open Market Committee meeting, the Fed announced that it would start allowing its MBS holdings to passively roll off by not reinvesting matured principal in June. This marks a new era for the Fed’s balance sheet following an aggressive pace of MBS purchases over the past two years (Box 1) which extracted volatility and risk premium from the market, propelling spreads to historical tights in mid-2021. MBS runoff will be capped at $17.5 billion during a “ramp-up” period from June to August before the cap increases to $35 billion in September. Raised prospects of active MBS sales within the next year have also challenged MBS performance. 
Source: Goldman Sachs Asset Management, Goldman Sachs Global Investment Research, Macrobond. As of April 2022.
Challenging supply and demand dynamics. Net MBS supply had been robust due to strong seasonal mortgage origination for home purchases. At the same time, investor demand has declined, with persistent fund outflows, while appetite from large commercial banks and foreign institutions has waned amid higher volatility and duration extension of holdings. Domestic bank holdings of agency MBS have decreased since January and demand may remain tepid if loan growth continues to pick up (given banks use MBS as a replacement for loans on balance sheets).
Higher rate volatility. Implied rate volatility has been stubbornly high due to sharp shifts in the Fed rate outlook and high uncertainty around real rates, the terminal rate and inflation due to both the war and pandemic. This challenges MBS performance in three ways. First, higher volatility raises hedging costs for some investors, deteriorating the economics of investing in the asset class. Second, the negatively convex profile of MBS can lead to underperformance relative to US Treasuries as volatility rises in a rising rate environment. Lastly, higher volatility weighs on demand from banking and other institutions.
Moving Overweight
Notwithstanding the tough environment that has been a drag on agency MBS returns since late 2021, we have migrated from an underweight to overweight position in the asset class for four key reasons:
Headwinds are largely priced. Significant weakness YTD suggests that the Fed’s balance sheet unwind, including the risk of active sales, has been largely priced in by mortgage market participants. Moreover, supply headwinds may ease given lower housing affordability due to higher mortgage rates suggesting mortgage origination—a primary driver of net MBS supply—will begin to slow.
Higher yields and wider spreads. Yields and spreads have increased significantly (Exhibit 2 and 3), reflecting economic uncertainty and Fed actions. In our view, these market moves have created attractive sector valuations and provide a carry cushion against lingering headwinds. The ICE BofAML US MBS index yield has increased by 174bps YTD to 3.7%. The yield differential between current coupon MBS and 10-year US Treasuries has more than doubled since the start of the year from 54bps to 132bps, entering its 99th percentile rank when benchmarked to the post-global financial crisis period1.
Exhibit 2: Wider spreads
Source: J.P. Morgan. Option adjusted spread (OAS). As of June 30, 2022.
Exhibit 3: Higher yields, better convexity
Source: Macrobond, ICE BofAML. As of June 30, 2022. Convexity is a measurement of duration sensitivity to changes in yield. MBS tends to have negative convexity, meaning that duration rises as yields increase. This is due to flexibility that mortgage payers have as to when they repay their loans—so-called prepayment risk.
Convexity has improved. The negative convexity profile of MBS typically weighs on returns as it extends MBS duration in rising rate environments and compresses it as rates fall. However, the convexity on the ICE BofAML US MBS index has turned less negative (Exhibit 3). This is because 98% of mortgage borrowers have mortgage rates below current mortgage rates2, and a meaningful 78% of the market is trading below $983. The migration of the mortgage market to higher rates and discounted prices has materially reduced a mortgage holders incentive to refinance which in turn reduces cash flow uncertainty for mortgage investors. The reduced convexity of the market also reduces uncertainty around the duration of MBS which could benefit investors with stricter duration constraints.
MBS can help to guard against growth risks. The defensive nature of the agency MBS sector can be beneficial for fixed income investors in an environment of decelerating—though still positive—economic growth. Moreover, in the event of a material growth deceleration, we believe MBS would likely outperform credit sectors due to lower sensitivity to cyclical developments and the potential for renewed monetary support.
Staying Selective
We believe high dispersion in performance across the agency MBS sector, depending on the issuer and coupon (Exhibit 4), underscores the importance of active management.
Exhibit 4: An “up-in-coupon” strategy has outperformed on an excess return basis
Source: Bloomberg, J.P.Morgan, Goldman Sachs Asset Management. As of June 30, 2022. Yield to worst (YTW), option adjusted spread (OAS), option adjusted duration (OAD), month-to-date (MTD).
We seek to navigate market dislocations to identify attractive investment opportunities. For example, our up-in-coupon strategy (which favors production coupon bonds over low coupon bonds) has performed well due to its attractive carry and valuation profile.
Looking ahead, we continue to believe production coupons will outperform low coupons given the latter faces headwinds from the Fed’s balance sheet unwind (Exhibit 5), including the prospect of active MBS sales. We also see value in Ginnie Mae mortgages over conventional mortgages due to attractive valuations relative to conventional mortgages and their own history, as well as a rotation in bank demand away from conventional mortgages.
Exhibit 5: Active Fed MBS sales would be most challenging for conventional 30-year 2% and 2.5% pools
Source: Bloomberg, Fed, Goldman Sachs Asset Management. As of June 30, 2022.
That said, we are mindful of headwinds to production coupons such as higher-than-expected supply. Overall, the shifting policy, supply and valuation backdrop requires dynamic sector allocations and active security selection.
1. Source: J.P.Morgan, Bloomberg. As of June 30, 2022. Post global financial crisis period is defined as Q3 2009 onwards.
2. Based on Freddie Mac Survey as of July 7, 2022.
3. Source: Goldman Sachs Asset Management, ICE BofAML MBS Index. As of July 7, 2022.
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