The end of the cheap money era brought plenty of trouble for the least risky mortgage-backed securities. Surging interest rates have made the coupons look meager, the Federal Reserve is shrinking its exposure, and the regional banking crisis left the regulator with about $100 billion of the bonds to sell.
But now, money managers are stepping into the gap, drawn by spreads that remain near historic levels.
“Mortgage bonds are just screaming cheap,” said Bryan Whalen, co-chief investment officer, and portfolio manager at TCW Group Inc.’s fixed-income group. “You have to squint to see these levels on charts going back 20 years.”
Doubleline Capital LP has increased its allocation to the asset class, while Pacific Investment Management Co. and Soros Fund Management LLC have added to their positions in recent months after prices of the repackaged government-backed home loans reached some of the cheapest levels since the global financial crisis. Demand is so strong that spreads are tightening as volatility subsides.
Despite that, agency mortgage-backed securities remain at a good value compared with other asset classes as banks turn sellers, said Dawn Fitzpatrick, chief executive officer at Soros Fund Management, at the Bloomberg Invest conference earlier this month.
Market Jitters
The tighter spreads have made money for those who bought last month. The risk premium was about 1.59 percentage points on Wednesday, compared with a post-crisis record of almost 1.93 percentage points in late May. That’s based on the difference between yields on current coupon mortgages and a blend of five- and 10-year Treasuries.
Back then, market jitters in the aftermath of the bank turmoil led to concerns that the Federal Deposit Insurance Corp. would struggle to sell more than $100 billion of securities that were previously held by failed lenders Silicon Valley Bank and Signature Bank. Much of the portfolio is agency-backed mortgage bonds.
The disposals began in April after BlackRock Inc. was hired to manage the process, with the broad expectation that it would take about a year to offload a portfolio that’s comprised mostly of securities with low-interest rates. The appetite of the asset managers means the FDIC has already sold about half of the mortgage securities.
Some of the buyers, to be clear, have long made government-guaranteed MBS a focal point of their investing strategy. And yet, their level of conviction now means that demand for the assets, including nearly $8.5 billion of MBS sold by the FDIC last week, remains red hot.
‘Scarcity Value’
“There’s a scarcity value to these bonds,” said Pat Ahn, a senior mortgage-backed securities trader at TCW. “That’s also been driving some of that solid execution.”
The interest from money managers means that the supervisor could finish the sales process by the end of the summer, according to Michael Khankin, a residential mortgage-backed securities analyst at Barclays Plc. Still, demand could slow if investors start to run out of cash, especially if it turns out that the FDIC sold off the best assets first, he said in an interview.
“It’s a legitimate concern, but it’s also worth noting that there’s a decent amount of cash out there,” he said. The government guarantee for agency MBS also limits the risk to bondholders if homeowners begin to default, making them very different from the subprime bonds sold before the financial crisis that subsequently contaminated the banking system.
Still, the market will need to absorb about $550 billion of mortgage debt this year, a “huge” amount, according to Vitaliy Liberman, agency MBS portfolio manager at Doubleline. That comprises about $250 billion in new supply, the FDIC sales, and about $200 billion from quantitative tightening, he said.
“Most of the market has woken up to the idea that mortgages are very attractive,” Liberman said, cautioning that they “see demand that, at times, is baffling to us in terms of the levels that people pay.”
Window Narrows
The wave of interest from money managers contrasts with a dearth of demand late last year that, coupled with rising interest rates, pushed bond prices to some of the lowest levels in a decade.
Agency MBS spreads subsequently reached a new low in May when a mixture of volatility, the regional bank crisis, and fears about the debt ceiling drove them to the widest level since the financial crisis.
There’s room for them to compress further, said Hyun Lee, senior portfolio manager of residential mortgage-backed securities at asset manager DWS Group GmbH. “We see a medium-sized opportunity given mortgages will likely tighten relative to Treasuries,” he said.
The spreads have also made them a more attractive bet relative to other investments, such as corporate bonds, which will boost the number of buyers, he added.
Agency MBS is the “most attractive asset” in the public markets, Pimco Chief Investment Officer Dan Ivascyn said in a Bloomberg TV interview earlier this month, noting that the firm has been adding them consistently across mandates. “You have a high-quality liquid asset trading at an incredibly attractive spread.”
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