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What you need to know about the second largest bond market in the world

22 May 2018

John Carey, head of structured securities at BNP Paribas Asset Management, explains why agency mortgage-backed securities perform well in rising rate environments.

By John Carey,

BNP Paribas Asset Management

The securities in the agency MBS (mortgage-backed securities) sector have an implicit or explicit US government guarantee and therefore has the same ‘AAA’ credit rating as a US Treasury security. There has never been a default to an investor in the agency MBS market in its entire history. The agency mortgage market is the second largest bond market in the world behind the US Treasury market.

While both agency MBS and US Treasury securities have the same credit quality, agency MBS have a yield pick-up because they have an additional risk: prepayment risk. Prepayment risk is the risk an investor gets their money back earlier than expected. This unique characteristic leads the sector to perform well in rising rate environments.

Why agency MBS versus non-agency MBS?

Quantitative Easing is Reversing – QE Winners Likely to Become Losers

Quantitative easing (QE) has crowded investors out of high quality asset classes like agency MBS and Treasuries and forcing investors into riskier credit sectors. This produced a virtuous cycle where high demand led to strong returns, which in turn led to high demand.

What happens when the music stops? When central banks decrease the size of their balance sheet, it stands to reason that the sectors that benefitted from central bank asset purchases will suffer from central bank balance sheet run-off.

Strong Liquidity

The below chart shows a series the Federal Reserve (Fed) tracks where they ask primary dealers, ‘how is your balance sheet allocated, and how much capital do you have allocated to the various different activities?’ We show three sectors: agency MBS, Treasuries and US investment grade corporates.

Agency MBS and US Treasury primary dealer inventories have been steady. Regulatory capital is very low for Treasuries and agency MBS, and therefore they are treated well in this evolving regulatory framework. Corporates, on the other hand, is a more challenging asset class for banks to own as a result of regulations put into place post-2008.

Therefore the amount of corporate inventory that primary dealers are willing to hold has shrunk considerably. The same is true for non-agency MBS.

Primary dealer inventories


Source: Federal Reserve; data as of April 25, 2018

At the same time we have had the dealer community backing away from sectors with credit risk, we have seen massive amounts of issuance.

The issuance chart below illustrates the amount of issuance of agency MBS, non-agency MBS, and US investment grade corporate bonds. Although we have seen a substantial amount of agency MBS issuance, the daily trading volumes are also very high. The market trades in excess of $200bn of agency MBS every single day. In the non-agency sector, markets only trade about $3bn per day. From a risk-adjusted return perspective, we believe owning agency MBS is an attractive trade.


Source: SIFMA, data as of 31 December 2017

Rising yields a positive technical

The good news for fixed income investors is that yields are higher now than they have been in a long time. The MBS index had a yield of 3.4 per cent at the end of April. The 30-year fixed rate Fannie Mae 4 per cent coupon has a yield of 3.7 per cent with a government guarantee and approximately 4.8 years of duration. This represents a substantial yield advantage over US Treasuries.

Agency MBS investors also benefit from less refinancing in a rising rate environment. There is a very important link between interest rates and mortgage refinancing activity. The chart below shows 10-year yields on the right-hand scale (inverted) and the refinancing index on the left-hand side. With mortgage origination rates now at 4.625 per cent, the 4 per cent coupon has fallen out of the refinancing window. This translates to slower prepayments due to less refinancing supply. Going forward we will have less mortgage supply which creates an attractive environment for slow prepayment speeds.

Refinancing Activity Strongly Linked to 10-year Yields

Source: Bloomberg, as of April 20, 2018

Additionally, mortgage investors can take advantage of higher yields faster than investors in other fixed income sectors. Agency MBS have large monthly cash flows from principal and interest payments, whereas Treasury and corporate fixed-income securities only have semi-annual coupons followed by a large principal return at maturity. The MBS sector thus provides investors the opportunity to reinvest interim cash flows in these higher yields.

What to Seek

We believe investors in agency MBS should seek to generate an attractive risk/return ratio. The key is to select securities with a high credit quality and that are well positioned in terms of their relative value so they strongly de-correlate from other components of a fixed income portfolio.

John Carey is head of structured securities at BNP Paribas Asset Management. All views are his own and should not be taken as investment advice.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.