stanciuc
stanciuc
By Jason W. Smith
In a world with a lot of unknowns, one thing we do know is that Agency MBS prepayments continue to be slow and steady.
When thinking about Agency mortgage-backed securities, it’s worth remembering the risk we investors are being compensated for.
Unlike credit sectors where the risk is largely whether you will get your money back, the “government-sponsored entity” wrapper of Agency MBS essentially takes that default risk away.
We are then left, not with the risk of whether, but rather when we may get our money back. The latter is driven by homeowner and servicer prepayment responses to their existing mortgages.
Assessing that behavior has historically been a challenge, as many factors are at play in those decisions, and some uncertainty. However, investors currently sit in an unusual position.
First, there were the historically low mortgage rates driven by quantitative easing (the current average outstanding mortgage rate is an amazingly low 3.80%).
Next came the normalization of interest rates to levels not seen in 20 years (current prevailing mortgage rates are around 6.80%).
The massive gap in mortgage rate levels and prepayment incentives have created the highest level of confidence in prepayment behavior seen in a long time.
In our view, that gap should persist even if/when the Federal Reserve does start a cutting cycle, making Agency MBS less sensitive to Fed policy than they have been historically.
It’s worth remembering this very positive fundamental backdrop when talking about opportunities in Agency MBS. While spreads are off the wides seen last year after the Silicon Valley Bank debacle, they remain attractive, in our view, given the fundamental risks.
While many options in Agency MBS can be employed to solve investor needs, we are focusing on two: first, by continuing to add fuller-coupon securities at slightly below or at par, and second, exploring heavily discounted dollar-price lower-coupon bonds that trade with additional spread.
In summary, the Agency MBS value proposition involves compensation via healthy spreads over Treasuries for risks due to the timing of cash flows. At a time when confidence as to that risk is fairly high, we feel that investors could continue to be in an enviable position.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.