Agency MBS: A broad investment universe
Sept. 27, 2018
The agency mortgage-backed securities (MBS) market is often associated only with physical pass-through pools, but the universe of investments is much broader. Agency MBS extend also to structured securities in the form of agency collateralized mortgage obligations (CMO) and forward contracts known as “To Be Announced” (TBA) contracts. This diverse universe can provide opportunities and help address some of the challenges investors face in the low yield environment. Here, we provide an overview of the investment universe of agency MBS, focusing on the unique features of the underlying security types and how, when managed in an absolute return investment style, they can help provide an attractive solution to address some of today’s market headwinds.
Investment universe overview
The agency MBS universe is a diverse opportunity set of physical pools, structured securities, and derivatives:
- Pass-through agency MBS pools are constructed with pools of securitized mortgage loans issued and guaranteed by US government agencies. These pooled securities are typically comprised of fixed-rate loans with terms of 30, 20, or 15 years, as floating-rate residential loans are less prevalent in the US.
- Agency CMOs are constructed from agency MBS pools by redistributing the principal and interest cash flows into tranches. Multiple structure types are available and include basic sequential, interest-only and principal-only, and planned amortization classes.
- TBAs are effectively forward-settling agency MBS where the parties agree to buy or sell on a specific future date. The basic characteristics of the pool to be delivered are agreed to upfront, with the specific pool announced 48 hours prior to the trade settlement date.
While these types of securities have different features that can play specific roles in a total portfolio setting, they all exchange credit risk (as the securities are government guaranteed) for prepayment risk. Prepayment risk reflects the optionality of these cash flows as US mortgage borrowers can repay the principal in full or in part at any time without penalty. An enhanced yield over the risk-free rate is paid to compensate for this prepayment risk.
Seeking to address the challenges faced by investors
Investors are increasingly seeking additional portfolio diversification tools as we enter the latter stages of an already extended economic cycle, where valuations are stretched and yields are low.
The agency MBS universe can provide an additional source of diversification, from both a correlation and a return perspective. Pass-through securities, certain CMO structures, and TBAs are uncorrelated to stocks, providing total portfolio protection in a risk-off environment. From a return perspective, the universe is unique in that it provides the opportunity to add additional returns from managing prepayment risk.
An example of extracting this alpha is found in investing in pass-through securities. We have noted that pools with low loan balances generally exhibit less prepayment sensitivity (due to lower dollar savings on rate decreases) and higher returns than equivalent pools with higher loan size balances. In CMO securities when rates are rising, interest-only structures tend to perform well as prepayments fall, resulting in interest being paid over a longer period on the principal outstanding.
In this low yield environment, many investors have had to move out on the risk spectrum and down the capital structure to generate returns, even in their defensive allocations. The agency MBS universe can provide some relief for those challenged with low returns and riskier holdings.
The asset class is AAA rated, has implicit and explicit backing of the US government, and provides an enhanced yield over the risk-free rate to compensate for prepayment risk.
Focusing on pass-through securities, compared to the other major fixed income and equity indices over a 24-year period, we find these securities offer less downside risk with milder drawdowns and lower quarters of negative returns, as illustrated in the chart below. Pass-throughs are also very liquid, are the second largest fixed income asset class after US Treasurys, and have high daily trading volumes.
Pass-through securities: Milder quarterly drawdowns
Source: Bloomberg and Securities Industry and Financial Markets Association. Monthly index data 1994–2018 for the Bloomberg Barclays indices US Mortgage-Backed Securities Index, US Treasury Index, US Corporate Investment Grade Index, US Aggregate Index, Global Corporate Investment Grade Index, and Global Aggregate Index; and for the MSCI World Index, and the S&P 500® Index.
The asset class can provide further risk management and protection benefits through the use of TBAs. This forward security allows portfolio managers to increase and decrease exposure to prepayment risk through a single transaction, allowing time to adjust the underlying security selection through fundamental research. This is particularly critical in times of rising prepayment rates.
Attractive return profile
Macquarie uses the agency MBS universe in an absolute return style investment solution (Macquarie Absolute Return Agency MBS) that targets LIBOR +3% through the cycle. The strategy uses a time-tested investment approach and has consistently delivered on this return objective1 while achieving a high information ratio and low volatility of returns.
The portfolio is constructed with a core of pass-through pools and CMOs that have been selected through in-depth fundamental research, an overlay component for hedging and other alpha opportunities, and overall duration management to position for the prevailing interest rate environment. The portfolio capitalizes on management of prepayment risk, which is a differentiation relative to credit investments.
The agency MBS universe is diverse in nature. At the asset class level, it provides a high-quality AAA-rated solution to investors with a government guarantee, and an additional alpha source in the form of managing prepayment risk. Each underlying security type offers its own unique features — from the highly liquid nature of pass-throughs, to the ability to strip out principal and interest in CMOs, to the flexibility of the TBA market in effectively altering prepayment exposure or extracting relative value.
Utilizing the full spectrum of the agency MBS universe, with a focus on fundamental research and capital preservation, can help investors with some of the return, risk, and diversification challenges they face today.
1Strategy has delivered in excess of LIBOR +3% over 3 and 5 years, as of Aug. 31, 2018.
The views expressed represent the Manager's assessment of the market environment as of September 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
An investment in the agency MBS series is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
The Bloomberg Barclays US Corporate Investment Grade Index is composed of US dollar-denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least one year to maturity.
The Bloomberg Barclays Global Corporate Investment Grade Index is a measure of global investment grade, fixed-rate corporate debt. This multicurrency benchmark includes bonds from developed and emerging markets issuers within the industrial, utility, and financial sectors.
The Bloomberg Barclays US Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
The Bloomberg Barclays Global Aggregate Index provides a broad-based measure of the global investment grade fixed-rate debt markets.
The Bloomberg Barclays US Treasury Index measures the performance of US Treasury bonds and notes that have at least one year to maturity.
The Bloomberg Barclays US Mortgage-Backed Securities (MBS) Index measures the performance of agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgage) issued by the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Association (Freddie Mac), and Government National Mortgage Association (Ginnie Mae).
The London interbank offered rate (LIBOR) is a composite of the rates of interest at which banks borrow from one another in the London market, and it is a widely used benchmark for short-term interest rates.
The MSCI World Index is a free float-adjusted market capitalization weighted index designed to measure equity market performance across developed markets worldwide.
The S&P 500® Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
All third-party marks cited are the property of their respective owners.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Diversification may not protect against market risk.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The Strategy may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
Securities in the lowest of the rating categories considered to be investment grade (that is, Baa or BBB) have some speculative characteristics.