Former Problem Children, Agency Mortgage-Backed Securities, Make Case for Inclusion in Core Bond Portfolios

Any conversation about agency mortgage-backed securities drums up residual feelings of unease, given the rout of the investment vehicle during the financial crisis of 2008 and 2009. However, new insights out from Capital Group’s fixed income portfolio manager Pramod Atluri, suggests that great upside exists in agency MBS, as the offering looks more attractive because of where yields have landed.

During the COVID-19 pandemic, the Federal Reserve acquired more than $1 trillion of agency MBS to ease monetary policy and provide stability.

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“This action in combination with others led yields to fall, mortgage durations to shrink, interest rate volatility to plummet and spreads to reach negative territory,” Atluri wrote. “By the end of 2022, all that had changed. The Fed’s hiking campaign and the fear that the central bank would offload MBS from its balance sheet led rates to rise, mortgage durations to extend, interest rate volatility to increase and spreads on agency MBS to reach some of the widest levels against Treasuries since the global financial crisis of 2008. In my view, each of the factors that led agency MBS to significantly underperform in 2022 are reasons to consider owning MBS in 2023.”

Citing a weaker housing market, in addition to slower growth and the tamping down of inflation, Alturi sees it as unlikely that the Fed will sell agency MBS into the market, and as this risk gets priced out, agency MBS valuations should rise. Furthermore, Alturi anticipates that interest rate volatility will steady, as a terminal interest rate is reached, benefiting agency MBS valuation further.

“Mortgage valuations have typically improved when interest rate volatility falls, because agency mortgage borrowers in the U.S. have an option to repay their loans early,” penned Alturi. “When rate volatility falls, the early payment option becomes less valuable to borrowers and the value accrues to mortgage investors.”

Comparing the opportunity in agency MBS against treasuries and other asset-backed sectors, Alturi wrote, “AAA-rated agency mortgage yields [begin] the year around 80 to 100 bps above Treasuries,” while highlighting that agency MBS duration profile is more attractive, given the current macroeconomic climate, than asset-backed offerings of credit card and auto loan syndications that exist.

Eaton Vance Investment Insights depict an environment not seen in the asset class since the early 2000s, not to invoke anxiety, but rather that sizable yields exist in the space for investors. “Higher-coupon agency MBS yields are now close to 6% for the first time since the early 2000s,” wrote Andrew Szczurowski, head of agency MBS and portfolio manager at the firm. “In our view, supply of agency MBS is set to fall significantly in 2023, as mortgage rates [at] 7% have dramatically slowed U.S. home sales and eliminated any cash-out refinance supply. Declining supply in 2023 should more than offset the absence of the Federal Reserve in the MBS market, providing a nice technical tailwind for MBS spreads.”

Alturi does not view CMBS as nearly as strong an opportunity as that presented by the residential equivalent: “I remain cautious on the fundamentals [of the commercial real estate space] and am not expecting to add in 2023. There is still an uncertain outlook post-COVID in terms of occupancy, and many properties are now refinancing at much higher rates.”

According to Federal Reserve data, national mortgage debt stood at $11.39 trillion at the end of June 2022, while at the end of 2022’s first quarter, the Federal Reserve recorded home equity value at $27.8 trillion. In data released on December 9, 2022, by Yardeni Research depicting Q3 projections, total household equity was $29.6 trillion, while mortgage debt was $12.4 trillion, providing a sizeable theoretical gap in equity for investors to feel secure in these securitized investment vehicles, which in the not-so-distant past were the scorn of the financial world.

Why the Worst Is Over for Mortgage-Backed Securities, Maybe

Mortgage Securities Deserve a Bigger Place in Pension Portfolios, DoubleLine Says

Tags: agency mortgage-backed securities, Andrew Szczurowski, Capital Group, Eaton Vance, MBS, Pramoud Alturi, Yardeni Research

The U.K.’s pension de-risking market is expected to have a record-breaking year in 2023 in terms of volume of buy-ins and buyouts, according to an analysis from London-based law firm Lane Clark & Peacock.

“2022 was a roller-coaster year but the average DB pension scheme starts 2023 in much better shape than a year ago,” Charlie Finch, a partner in LCP’s de-risking practice, said in a statement. “Alongside more transaction volumes, we expect to see a further increase in the number of large schemes using buy-ins and buy-outs rather than self-sufficiency.”

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The firm projects a sharp rise in demand for buy-ins and buyouts this year and in coming years, which it attributes to a significant improvement in funding in 2022. It said the average full buy-in/buyout funding level improved by approximately 15%, and plans jumped more than five years forward toward being fully funded against the cost of full insurance.

In light of the expected increase in de-risking activities, LCP is urging plans that are considering a deal to “get their homework done so they are transaction ready and fully prepared before they enter the market.”

In its analysis, LCP provides five predictions for the market in 2023:

1. Buy-in/out volumes will be at their highest ever.
LCP said it expects buy-in and buyout volumes to top the record £43.8 billion ($53.3 billion) reported in 2019, despite gilt yields being much higher than they were four years ago. However, a busy market means pension plans “will need to work doubly hard to get ready and ensure that insurers will want to participate.”

2. Pricing will continue to be attractive for plans that prepare properly.
LCP says pricing is currently at “historically attractive levels” for both retirees and deferred retirees. The firm expects attractive pricing will remain available for plans that have “positioned themselves attractively” to insurers in 2023 if current market conditions continue. However, it anticipates the plans will “have to work much harder than in the past to secure active insurer participation.”

3. There will be fewer partial buy-ins, fuller buy-ins.
Pensions are now working with higher collateral levels to protect against future gilt yield rises following the 2022 bond market meltdown. LCP’s position is that this means there is less capacity for younger plans to conduct partial buy-ins. For larger plans, “this may tilt the balance from using buy-ins to using longevity swaps to hedge longevity risk, but care needs to be taken as longevity swaps themselves typically require collateral.”

4. New innovation will help address the illiquid asset challenges for plans.
The illiquid assets held by some plans are an increasingly common barrier to full insurance, the LCP report said. Because this has been exacerbated by the LDI crisis, the firm predicts new innovations will address this challenge, such as better ability to transfer illiquids to insurers with innovative deferred premium structures and other options that help preserve value.

5. An increased chance of a new entrant entering the buy-in/out market.
Because there has not been a new entrant in the bulk annuity market in several years, LCP predicts that 2023 has “the highest chance that a new entrant emerges” due to the changing supply-and-demand dynamics in the market. The firm expects any new entrant to be an existing insurer because of the high barriers to entry.