AAA agency mortgage-backed securities don't just outperform in risk-off environments


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By Andrew Szczurowski, CFADirector of Mortgage-Backed Securities, Eaton Vance Management and Alexander Payne, CFAPortfolio Manager, Mortgage-Backed Securities, Eaton Vance Management

Boston - After a dramatic backup in U.S. Treasury yields in late February and early March, are we entering a new bear market? Our fixed income investment experts present their views on the environment in a series of blogs, continuing with agency MBS.

With the Bloomberg Barclays U.S. Aggregate Bond Index (Agg) on pace for its worst quarter in 40 years, many investors may be wondering if there is a safe place in the bond market to park their cash that won't hurt them if interest rates continue to rise.

While there has been a large backup in intermediate and long-end U.S. Treasury yields, with the 10-year selling off by over 120 basis points (bps) from the lows of summer 2020, we are still at abnormally low levels historically. In fact, despite the large sell-off in intermediate and long-end Treasurys, yields have only risen to the level where the 2013 taper tantrum began.


Source: Bloomberg, Eaton Vance. As of 3/23/2021.

The sell-off has been painful for many bond investors and our view on the mortgage-backed security team is that the path of least resistance for Treasury yields is higher, as the U.S. economy recovers and U.S. deficits balloon after three stimulus bills — along with the potential for an infrastructure package to throw even more supply onto an already bloated bond market.


Source: Bloomberg, Eaton Vance. As of 3/23/2021.

If yields do continue to rise, one sector that has historically outperformed other high quality parts of the bond market is the AAA-rated agency MBS market. In fact, in past rising rate environments, agency MBS have consistently outperformed both the Agg index and the investment-grade corporate bond index by more than 60 bps on average.1


Source: Morningstar. As of 2/28/2021. Past performance is no guarantee of future results.

1 Rising rate periods are defined as 3-month rolling periods in which 10-year U.S. Treasury yields rose by 40 bps or more.

Over the past two years, the agency MBS market has been dealing with a refinance wave thanks to record-low mortgage rates, which subsequently caused MBS supply to hit new record highs, seemingly month after month. However, the recent rise in Treasury yields and mortgage rates has led to a reversal in that trend. Daily MBS origination has dropped sharply in March, down more than 30% from its record high hit in February 2021.


Source: JP Morgan. As of 3/24/2021.

From our standpoint, this backup in rates is actually welcome news. We have shown how higher mortgage rates can lead to lower refinancing activity, next we examine the link between prepayments and MBS returns. At current prices for a Ginnie Mae 2.5% pool, every 5% change in the annualized prepayment rate is worth approximately 20 bps of yield, all else being equal. Market projections have slowed by roughly that amount year-to-date, with the consensus annualized prepayment rate dropping from the high to low teens.

A quick review of Google Trends would suggest that even though the rate backup is relatively recent, it is already having an impact. There appears to be waning interest in refinancing as mortgage rates have moved up from their summer lows.

Google Trends search activity for the term: refinance


Source: Google Trends. As of 3/24/2021.

Google Trends is a search feature that shows how frequently a given search term is entered into Google's search engine relative to the site's total search volume over a given period of time.

Market technicals in 2021

Technicals in the agency MBS market will likely go from a large headwind in 2020 to a tailwind for the foreseeable future. The Federal Reserve is currently adding $40 billion agency MBS on a net basis to their balance sheet every month, which means that if they don't taper their purchases at some point, they will be buying $480 billion for the year. Further, after the recent backup in mortgage rates, supply estimates of agency MBS for 2021 have fallen to only $400 billion. Absent a taper from the Fed later this year, there could potentially be -$80 billion of net supply.

Our view is that the Fed will have to taper at some point in 2021, given the continued economic recovery and rising Treasury yields/mortgage rates. But if the taper comes at a time of even higher mortgage rates and lower supply, it would be easier for the MBS market to digest.

Bottom line: We believe that while the path won't be a straight line higher like it has been for the past six months, Treasury yields will continue to rise over the coming quarters as the U.S. economy returns to a slightly more normal state. In our opinion, investors may want to look to the AAA-rated agency MBS market, which has not only historically outperformed in risk-off environments, but has also traditionally outperformed investment-grade corporates and Treasurys in rising rate periods.

Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.