The residential mortgage-backed security (MBS) market has experienced changing dynamics over the past couple of years. At the onset of the COVID-19 pandemic in 2020, the Federal Reserve (Fed) resumed quantitative easing as a way to stimulate the economy by keeping mortgage rates low, and grew its holdings of agency MBS to over $2.7 trillion.1
Fiscal stimulus and a country in lockdown contributed to a personal savings glut that greatly increased deposits at U.S. commercial banks. These banks then purchased large amounts of securities, including agency MBS, against the deposits. The dominant presence of the Fed and commercial banks left spreads on mortgages at relatively tight levels and kept other buyers out of the market.
Fast forward to today, and the two major buyers of the past couple of years have stepped back from the mortgage market. The Fed is now in the process of balance-sheet runoff. Commercial banks are seeing loan growth pick up while savings and deposits decline. Rising interest rates have also impacted the ability of banks to purchase mortgages. The mark-to-market and duration extension on existing holdings have added constraints on banks that might seek to buy additional MBS.
For other MBS investors, mortgages are starting to look more attractive from a relative value standpoint. While spreads across fixed income asset classes have widened this year, mortgage spreads have also been adversely impacted by rising interest rate volatility. The reason is that investors require compensation for the options homeowners have to refinance their mortgage if rates fall or keep their mortgage longer than expected if rates rise.
As this Chart of the Week depicts, the recent widening in MBS spreads from August to the present has coincided with the ICE BofA Interest Rate Volatility (MOVE) Index, which measures interest rate volatility, rising to its highest level this year. The increased volatility also impacts mortgage rates themselves, as 30-year rates have risen from 3.27% to 7.35% this year compared with a rise in 10-year Treasury yields from 1.51% to 4.17%.2
Key Takeaway
Spreads and all-in yield levels for MBS have caught the attention of investors. However, a common concern has been the risk that spreads could move even wider, given the uncertainty surrounding interest rates and the Fed’s actions in its fight against inflation. For investors that can withstand the volatility, MBS may present more of an investable opportunity than it has prior to this year.
Sources:
1Source: Axios- The Fed's $2.7 Trillion Mortgage Problem; 5/18/22
2Source: CNBC- U.S. 10 Year Treasury; as of 11/9/22
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