Brandywine Global: Agency mortgage-backed security valuations are attractive to us and reinforced by improving fundamental drivers.
We identified the opportunity in agency mortgage-backed securities (MBS) in the fourth quarter of 2022, based on the cheap valuation of agency MBS spread to US Treasuries. MBS valuations are attractive to us both relative to their own post-global financial crisis (GFC) history and relative to investment grade corporate bonds. In addition, the value proposition thesis is reinforced by two improving fundamental drivers: one is the diminishing negative convexity due to the “out-of-the-money” status of mortgage holders’ incentive to refinance; the other is the potential moderation of interest rate volatility, which should bode well for MBS due to its embedded short in volatility. Lastly, we believe the dwindling organic supply and the increasing demand from money managers provide a favorable market technical for this investment.Home prices peaked in March 2022 and continued to slow to an 8.64% year-over-year rate of increase by October.1 More importantly, we observed a bifurcation between drastically slowing housing activities, including home sales, new home starts, etc., and relatively better-supported home prices, wherein the latter outperformed the former. The major driver behind this anomaly is the still low supply of existing homes due to the lock-in effect of existing homeowners. The sharp slowdown in housing activities indicates lower organic supply of MBS, slower prepayment speed, and less paying down of the Federal Reserve’s MBS holdings (see Chart 1). This outcome is more favorable for production coupon MBS than discount coupon MBS.
Year-Over-Year % (not seasonally adjusted), as of November 30, 2022.
Source: Bloomberg (©2023, Bloomberg Finance LP). The Pending Home Sales Index (PHS), a leading indicator of housing activity, measures housing contract activity, and is based on signed real estate contracts for existing single-family homes, condos, and co-ops. The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan areas. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is no guarantee of future results.
The MBS spread to US Treasuries peaked in late October and has compressed by about 40 to 50 basis points (bps) along with the interest rate volatility declining (see Chart 2).
As of January 9, 2023
Source: Bloomberg (©2023, Bloomberg Finance LP). The MOVE Index measures US interest rate volatility. The index tracks the movement in U.S. Treasury yield volatility implied by current prices of 1-month over-the-counter (OTC) options. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is no guarantee of future results.
At the same time, the spread between investment grade corporate bonds and MBS option-adjusted spread (OAS) is still rather tight, which suggests more room for MBS spreads to tighten relative to higher-grade corporates since the corporate bond valuations are richer than the MBS historical pattern (see Chart 3).
Basis points, as of January 6, 2023
Source: Bloomberg (©2023, Bloomberg Finance LP). The corporate component is from the Bloomberg US Aggregate Bond Index, an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. Bloomberg US Mortgage-Backed Securities (MBS) Index tracks the performance of fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is no guarantee of future results.
Agency MBS are starting to exhibit almost positive convexity, which is unprecedented in history, providing what we believe to be great fundamental value (see Chart 4).
As of January 6, 2023
Source: Bloomberg (©2023, Bloomberg Finance LP). The Bloomberg US Mortgage-Backed Securities (MBS) Index tracks the performance of fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is no guarantee of future results.
We believe the opportunity in agency MBS has more room to run. Factors that should continue to support the investment include: the further moderation of interest rate volatility, resulting from the Federal Reserve’s effective taming of inflation and expected monetary pivot; the least negative convexity seen in some time—and even the potential for convexity to turn positive—unlocking fundamental value; and more buying interest from money managers, banks, and potentially even foreign buyers. There are some potential risks to consider though. Interest rate volatility could increase rather than moderate, triggered by runaway inflation and/or a major selloff in the global sovereign bond market. While not expected, the latter could be sparked by an event like an abrupt change in the Bank of Japan’s yield curve control, for example. Overall, however, we believe agency MBS should outperform other spread products in a recessionary scenario in 2023.
Agency mortgage-backed securities (MBS) are asset-backed securities secured by a mortgage or collection of mortgages issued by federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae.
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed. As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.
Coupon is the periodic interest payment made to the bondholders during the life of the bond.
Production coupon MBS bear a coupon rate close to the prevailing interest rates for similar investments at the time of issue.
Discount coupon MBS bear a coupon rate lower than prevailing interest rates for similar investments at the time of issue.
An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.
“Out-of-the-money” options are those that would generate a loss if exercised, and typically aren’t exercised, while “In-the-money” options are those which would generate a positive return if exercised.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
Source: A New Year’s resolution on agency MBS | Franklin Templeton
