In the desert of high-quality fixed income instruments bearing negative interest rates, US mortgage-backed securities, a triple ‘A’ rated asset backed by an implicit government guarantee, stand out like an oasis with their positive yields. John Carey, Head of Structured Securities at BNP Paribas Asset Management, explains the role US mortgage-backed securities (MBS) can play in adding yield to a portfolio.
In global bond markets, around USD 15 trillion of bonds currently offer negative yields. In contrast, US 10-year Treasury bonds, buoyed by talk of a reflationary ‘blue wave’, currently yield 0.86%, which is their highest level since June.
However, the yield on US agency mortgage-backed securities (MBS) is even better. Currently, the benchmark MBS issue, Fannie Mae’s 2% 30-year bond, yields a higher 1.34%. This is a short-duration asset; its current yield equates to around 1% over a comparable US Treasury bond. In my view, that is a very attractive yield pick-up for a high-quality asset class with an implicit guarantee from the US government.
For investors whose base currency is the euro, US agency MBS offer positive yields on a hedged basis. Given that German 10-year government debt currently yields around minus 0.60%, agency mortgage-backed securities compare very well.
In September 2008, in the wake of the Global Financial Crisis (GFC), the US Federal Housing Finance Agency (FHFA) used its authority to place Freddie Mac and Fannie Mae into conservatorship. The FHFA established the two conservatorships in response to a substantial deterioration in the housing markets that severely damaged each enterprise’s financial condition and left both of them unable to fulfil their missions without government intervention.
In the period since, these government-sponsored entities (GSEs) have been the subject of numerous reforms. Underwriting of loans has improved and prospective homebuyers must now make a 20% down-payment (NINJA loans – no income, no job, no asset – common prior to the GFC, are now rare, if not extinct). Their mortgage selection processes have improved and fees (insurance premiums) have been raised.
Moreover, very few US mortgage borrowers today have negative equity (where the value of their mortgage exceeds the value of their property). Housing prices have appreciated strongly in the US in recent years backed by what, until recently, was a strong labour market. This, along with the reforms described above, has helped improve the profitability of the GSEs, so much so that they have paid USD 292 billion in dividends to the Treasury through May 2019, according to a Congressional Research report.
Progress on reforms and improving profitability have led to calls to move the GSEs out of conservatorship. However, we think this is unlikely in the near future and, as an initial step, we would expect a move from an implicit guarantee to an explicit full faith government guarantee on US agency MBS.
As I have already mentioned, US Treasury bond yields have risen recently as investors have priced in the possibility that the election of a Democratic administration next month could result in reflationary policies. For example, a large stimulus package could push Treasury yields higher. As the Federal Reserve’s policy rates are currently anchored at zero, the result would be a steeper yield curve.
For the agency MBS market, I believe that would be a positive development. Remember, the key risk to MBS is prepayment and refinancing. Mortgage-backed securities are pass-through securities with a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects the payments on the loans and ‘passes through’ the principal and interest to the security holders on a pro rata basis.
In today’s low yield environment with US mortgage rates close to all-time lows (see Exhibit 2 below), refinancing mortgages is attractive for borrowers. As a result, there is considerable supply of MBS with principal and interest being ‘passed through’ to holders of MBS. This explains the 1% spread mortgages offer over US Treasury bonds.
Were US interest rates to rise, more and more borrowers would find it less attractive to refinance their mortgages. That in turn would mean lower prepayments, which would give us as MBS investors more certainty about cash flows in an environment with a lower supply of new bonds. Under these circumstances we would generally expect the spread offered by agency MBS to tighten.
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