As yields on the benchmark 10-Year US Treasury bond have risen in recent weeks, as markets have priced in an economic recovery in 2021, of the back of multiple COVID-19 vaccines currently in the works, and the incoming Biden administration, the end result could be a reflationary environment. For example, a large economic stimulus package, and increased fiscal spending, could push yields on US Treasuries higher. That, coupled with the US Federal Reserve’s monetary policy setting rates at record lows, the end result would be a steeper US yield curve.
For US MBS, we believe this scenario would be a positive development for the asset class. Since mortgage-backed securities are considered pass-through securities, with direct exposure to an underlying pool of mortgage loans, the strength of the US residential market provides a much more solid foundation for this asset class, relative to the environment just before the 2008-2009 GFC.
If US interest rates were to rise, more mortgage borrowers would find less incentive to refinance their mortgages. That in turn would mean lower prepayments, which would give US MBS investors more certainty about cash flows in an environment with a low supply of new fixed-income securities. Under this scenario, we would expect the spread offered by US MBS to tighten relative to the US Treasury counterparts.
Nonetheless, in today’s low-yield environment, with US mortgage rates close to all-time lows, mortgage refinancing has become much more attractive for borrowers in recent years. Consequently, 1.00% spread US MBS offer over US Treasuries, in an effort to compensate investors for increased refinancing and prepayment risk. As a result, there is ample supply of US MBS with interest and principal being ‘passed through’ to US MBS investors, making this area of the fixed income market quite attractive for those looking for yield in our view.
“Reaching for Yield”: US Mortgage-Backed Securities
As investors search for yield in an environment where high-quality fixed income securities offer negative interest rates, US mortgage-backed securities offer attractive opportunities with their positive yields.
“Stand Out from the Crowd” – US Mortgage-Backed Securities
In an environment where there is over US$15.6 trillion of bonds offering negative yields, it is getting increasingly difficult for investors to find quality investments that offer attractive yields. Despite this trend, one area of the global fixed income markets that appears to be a “diamond in the rough” are US mortgage-backed securities (“MBS”) – a high-quality asset class that offers attractive positive yields with an implicit guarantee from the US government.
“Full Faith in Credit?”– US MBS and Government Guarantee
In the wake of the 2008-2009 Global Financial Crisis (“2008-2009 GFC”), the US Federal Housing Finance Agency (“FHFA”) used its authority to place the federally-backed home mortgage companies Fannie Mae and Freddie Mac into conservatorship. The two conservatorships were established in response to a substantial deterioration in the US housing markets that severely damaged the financial condition of both entities, and left both of them unable to conduct their operations without the US government stepping in.
Since then, the two government-sponsored entities (“GSEs”) have been subject to various government reforms. The underwriting of loans has improved significantly since the 2008-2009 GFC, with prospective homebuyers now having to make a 20% down-payment on new home purchases. Furthermore, the infamous “NINJA” loans – no income, no job, no assets – popular prior to the 2008-2009 GFC, are all now but extinct. In addition to greater market stability, the mortgage selection and approval processes has improved substantially, while insurance premiums have been increased.
Furthermore, the US residential housing market is further supported by today’s US mortgage borrowers who have less negative equity, while home prices have seen a strong upward trend across the US, recently supported by a strong labour market and steady immigration, prior to the COVID-19 pandemic. These market trends, coupled with the reforms above, have helped improve the stability and profitability of both Fannie Mae and Freddie Mac, so much so, that they have paid almost US$200 billion in dividends to the US Treasury through May 2019, according to a US Congressional Research report.
The steady progress on reforms and improving profitability of Fannie Mae and Freddie Mac have led to growing calls for the US government to bring the two GSEs out of conservatorship. In our view, we think this is unlikely in the near term, especially in the midst of the COVID-19 pandemic. Further, we also expect that any move to bring the two entities out of conservatorship would include, as a first step, an explicit full faith government guarantee on US agency MBS, as opposed an implicit guarantee.
“A Rising Tide Lifts All Boats” – Rising Rates Will Benefit US MBS
As yields on the benchmark 10-Year US Treasury bond have risen in recent weeks, as markets have priced in an economic recovery in 2021, of the back of multiple COVID-19 vaccines currently in the works, and the incoming Biden administration, the end result could be a reflationary environment. For example, a large economic stimulus package, and increased fiscal spending, could push yields on US Treasuries higher. That, coupled with the US Federal Reserve’s monetary policy setting rates at record lows, the end result would be a steeper US yield curve.
For US MBS, we believe this scenario would be a positive development for the asset class. Since mortgage-backed securities are considered pass-through securities, with direct exposure to an underlying pool of mortgage loans, the strength of the US residential market provides a much more solid foundation for this asset class, relative to the environment just before the 2008-2009 GFC.
If US interest rates were to rise, more mortgage borrowers would find less incentive to refinance their mortgages. That in turn would mean lower prepayments, which would give US MBS investors more certainty about cash flows in an environment with a low supply of new fixed-income securities. Under this scenario, we would expect the spread offered by US MBS to tighten relative to the US Treasury counterparts.
Nonetheless, in today’s low-yield environment, with US mortgage rates close to all-time lows, mortgage refinancing has become much more attractive for borrowers in recent years. Consequently, 1.00% spread US MBS offer over US Treasuries, in an effort to compensate investors for increased refinancing and prepayment risk. As a result, there is ample supply of US MBS with interest and principal being ‘passed through’ to US MBS investors, making this area of the fixed income market quite attractive for those looking for yield in our view.
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