At the long end of the yield curve, we expect bond yields to rise on the back of market concerns that the US Treasury will need to ramp up debt issuance to fund the government’s continued deficit spending. That contributes to the curve steepening.

We believe US agency [1] mortgage-backed securities (MBS) is an attractive asset class for fixed income investors right now: valuations are low; it offers a strong source of income; the supply and demand dynamics on this market are positive; and it has the ability to outperform other market segments once the US Federal Reserve starts cutting interest rates.

Yields – On current coupon MBS, yields are at 6% – that is 150bp over comparable equally low risk US Treasuries. We expect current coupon spreads to fall to 125bp in the near term and to 100bp  longer term.

Supply – Rates on new mortgages are above 7%, limiting housing market activity which in turn is capping the supply of new MBS issues.

Demand – Banks have started to add MBS, but are still mostly on the sidelines. Bank interest is expected to pick up once regulatory rules are finalised in August and once the Fed starts cutting rates.

Furthermore, the high market liquidity and attractive (credit) quality profile of US agency MBS mean the segment can withstand market stress if the path to Fed rate cuts is not a straight line.

Relative to US corporate bonds, the current context favours US agency MBS. Yield spreads of corporate debt over US Treasury bonds have rarely been narrower since the Global Financial Crisis. Looking at developed credit markets more broadly we see signs of deteriorating fundamentals in the credit segment. This leads us to believe corporate credit’s strong run is coming to an end.

Read the full report entitled Why US agency MBS? Why now?

References

[1] Issued by government-sponsored enterprises (GSE) such as Fannie Mae, Freddie Mac, and Ginnie Mae; also see https://www.investopedia.com/terms/a/agency-mbs-purchase.asp