Agency Mortgage-Backed Securities Offer Attractive Yields Amid Market Shifts
Despite current headwinds, agency mortgage-backed securities (MBS) are presenting investors with compelling opportunities, offering elevated yields and enhanced portfolio diversification.
Washington D.C. – Agency mortgage-backed securities, bonds backed by U.S. mortgage loans and guaranteed by government-sponsored enterprises like Fannie Mae (OTC:), Freddie Mac (OTC:), and Ginnie Mae, are currently trading at levels that analysts say represent a significant value proposition. Historically, these securities have delivered returns exceeding those of U.S. Treasuries throughout various economic cycles, and their inherent liquidity makes them a cornerstone of many fixed-income portfolios.
Understanding the Current Market Dynamics
Currently, agency MBS are exhibiting wider spreads – the difference in yield between the bonds and benchmark Treasury securities – compared to investment grade corporate bonds. Typically, agency MBS maintain tighter spreads than corporate bonds due to the absence of credit risk inherent in the government guarantees. However, the current market presents an anomaly.
“The reason agency mortgages are trading so wide today is, in short, because of the excess supply within the agency mortgage market,” stated one analyst. This excess supply stems from two primary factors.
The Impact of Federal Reserve Policy and Banking Sector Shifts
The first contributing factor is the Federal Reserve’s ongoing quantitative tightening (QT) policy. As the Fed allows its balance sheet to shrink, it effectively adds approximately $15 to $20 billion in agency MBS supply to the market each month.
The second key driver is a reduction in demand from the U.S. banking sector. Deposit declines experienced in 2022 and 2023 have curtailed banks’ ability to purchase mortgages, leaving a void in demand for agency MBS. With these two significant buyers stepping back, spreads have widened in the absence of alternative purchasers.
Looking Ahead: A Path to Normalization
While the Fed is unlikely to re-enter the agency MBS market, the impact of QT is expected to diminish over time as the pace of balance sheet reduction slows.
“The negative impact of QT declines with time,” a senior official noted. Furthermore, expectations are for increased bank participation in the agency MBS market beginning in 2025, as banking sector conditions stabilize.
Investment Strategy and Portfolio Implications
Despite the current challenges, investors are finding opportunities in the wider spreads. “While we expect spreads to tighten in agency MBS over time, with elevated current yields and wide spreads, we are earning an attractive yield while we wait for these spreads to normalize,” according to a company release.
Several firms have significantly increased their investments in agency MBS, both through dedicated mandates and across broader multi-sector fixed income portfolios. This strategic allocation allows for enhanced credit quality, increased yield, and a more defensive portfolio posture without sacrificing returns.
This approach allows investors to capitalize on the current market conditions while positioning themselves for potential gains as spreads normalize and the market finds equilibrium.
