The fixed income market faces significant uncertainty related to the Fed’s plans to unwind its balance sheet. The unwind follows nine years of quantitative easing (QE) that emanated from the financial crisis. Historically, monetary policy has focused on controlling short-term interest rates through the Fed Funds Effective Rate. However, with QE, the Fed took a different path to stimulate the economy, embarking on large-scale asset buying of U.S. Treasuries and agency Mortgage-Backed Securities (MBS), steps that were designed to keep longer-maturity yields lower.
The Fed’s balance sheet unwind is widely expected to begin this month. Therefore, a large buyer of Treasuries and MBS is poised to gradually exit the market (Figure 1). We examine the mechanics and impact of this tapering on the MBS market.
QE and MBS
By keeping longer-maturity rates lower, QE programs facilitated the availability and affordability of credit to borrowers with the goal of stimulating economic growth. Housing contributes between 12 and 16 percent to U.S. GDP,1 so the inclusion of MBS as a significant portion of QE purchase programs made sense. Having a predictable and technical bid in the market for both Treasuries and MBS kept underlying interest rates (Treasury bonds) low and mortgage spreads (MBS) tight, which flowed through to consumers’ wallets in the form of low mortgage rates.
Figure 2 shows the levels of MBS spreads at the various QE program announcement dates since the crisis. QE purchases that included MBS, also known as net MBS “buying” programs, are denoted in green in the box below; these usually resulted in MBS spreads tightening (mortgages relatively cheaper for home buyers). QE purchases not focused on MBS are denoted in light blue in the box; these generally resulted in MBS spreads widening (mortgages relatively pricier for home buyers).
The Fed is actively removing accommodative monetary policy and therefore, according to traditional econometric models, the Fed does not need to buy as much MBS to stimulate growth. Fed officials have long discussed – and markets have long anticipated – that once the Fed Funds Effective Rate approached a more-neutral rate of 1.5 percent, the Fed could begin to decrease the size of its balance sheet and diminish any political ramifications of its role in providing residential mortgages.
At the June FOMC meeting, the Fed announced the operational details for its balance sheet unwind. Throughout QE, the Fed has reinvested Treasuries that have matured and MBS that has been “paid down”2 on its balance sheet into new Treasuries and MBS, dollar for dollar. The Fed will still be buying MBS, but instead of reinvesting the paid-down MBS dollar for dollar, it will only reinvest above a certain cap amount. The cap will start at $4 billion per month and gradually ramp up to a terminal level of $20 billion per month.
In recent months, Fed officials have emphasized that tapering will be gradual and predictable. The analysis of paydowns for the Fed’s holdings is no different than that for other MBS investors; unscheduled paydowns are interest rate dependent and inherently unpredictable. That is, when interest rates decline, unscheduled prepayments accelerate as the underlying mortgage borrowers refinance. The Fed must then reinvest more cash back into new bonds. Similarly, when interest rates rise, unscheduled prepayments slow as the underlying borrowers move “out of the money.” This leaves the Fed with less cash to put to work.
For example, when the 10-year Treasury bond traded in a range of 1.5 to 1.8 percent last fall, the Fed reinvested about $40 billion per month. After the election-induced Treasury sell-off, with the 10-year Treasury hovering around a range of 2.2 to 2.6 percent, reinvestments have fallen to about $20 billion per month.
The cap method assures that a fixed amount of reinvestments will be tapered each month. Above the cap amount, the Fed will still be reinvesting a quantity equal to what was paid down from their portfolio.
Potential Impact to the MBS Market
We view the current landscape in the MBS market as an opportunity for clients with the ability to invest in this asset class. Even though the cap structure may introduce less volatility than some other unwind structures, we expect MBS spreads to widen, with street estimates at a range of 5 to 30 basis points (bps). Given that most Fed holdings lie in 30-year MBS, we expect the longer end of the MBS curve to take the brunt of the widening.
Through a relative-value lens, we believe that some of this widening has already been priced into the MBS market. Figure 3 illustrates the historical relationship between corporate bond spreads and mortgage option-adjusted spreads. Mortgage spreads have underperformed corporates so far this year, which has reduced the pickup in spread from MBS to corporates. In fact, the corporate-MBS spread differential has fallen to multiyear tights. This improvement in relative value could act as an attractive entry point for investors in large part due to tight spreads in competing asset classes.
In addition, there are diversification benefits to adding agency MBS to certain client portfolios,3 which is particularly valuable as both equity and fixed income markets adjust to the U.S. rising rate landscape. Agency MBS is one of the largest and most-liquid sectors in the U.S. bond market, accounting for almost 30 percent of total outstandings.4 Agency MBS has a negative 0.65 percent correlation with the S&P 500, highlighting the diversification benefits for clients also holding equities.5 Furthermore, agency MBS has outperformed investment-grade corporates in each of the last three Fed rate-hiking cycles (Figure 4).
At Breckinridge, we believe we are poised to take advantage of opportunities in MBS as well as other investment-grade fixed income asset classes including U.S. Treasuries, corporate bonds, municipal bonds and securitized products. Our highly collaborative investment process provides us with an acute cross-asset view of markets and allows us to knowledgeably analyze relative value. In addition, we believe our proprietary systems allow us to efficiently scrutinize the market for opportunities. By digging deep into the underlying collateral and projecting future prepayments, we can hand-select bonds that should behave in a manner that is consistent not only with our clients’ specific investment objectives, but also with our overarching investment strategies.
 U.S. Bureau of Economic Analysis, 2Q17.
 “Paid down” refers to the mortgage borrowers underlying MBS repaying their mortgage loans via scheduled or unscheduled payments.
 Agency MBS may not be suitable for all client portfolios. Clients should speak with their financial advisors before making any investment decisions.
 SIFMA as of June 2017.
 According to 10 years of quarterly total returns as of 6/30/17, per Bloomberg/Barclays indices.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.