For investors seeking both risk mitigation and risk-adjusted returns, the diverse mortgage-backed securities (MBS) market can potentially deliver both – regardless of the rate environment.
- Using multiple sub-asset classes with different risk and return parameters within a core fixed income allocation may allow for additional diversification.
- We believe agency MBS are an often-overlooked component of traditional fixed income that are uniquely positioned to help investors navigate volatile rates markets.
- In our view, active management is critical to identifying opportunities for risk-adjusted returns in the large and diverse MBS market.
For much of the last three years, conversations about fixed income have been dominated by the specter of rising rates and how they would impact fixed income allocations. With recent humbling market developments and the ever-changing dynamics of the global economy causing greater uncertainty across asset classes, we believe there is an opportunity to explore certain components of traditional fixed income allocations that are often overlooked.
One asset class we feel is uniquely positioned to help fixed income investors further diversify and navigate uncertainty in rates markets is agency mortgage-backed securities (MBS).
Agency vs. Non-Agency MBS
The MBS market is a diverse sub-asset class that currently comprises more than $9.7 trillion in assets.1 The primary differentiator within MBS is agency versus non-agency. Agency mortgages are issued or guaranteed by government sponsored entities (GSEs) and, therefore, carry the same credit rating as that of U.S. government and government-issued debt securities such as U.S. Treasuries. As a result, agency MBS carry little to no credit risk, particularly when compared with non-agency mortgages.
The presence of credit risk within non-agency MBS can, in some cases, give these securities personalities comparable to those of single-sector credit exposures, such as high yield. By contrast, the limited credit risk of agency MBS gives the asset class a more core, traditional fixed income-style risk profile. Our discussion here focuses primarily on agency MBS, in which the risk-adjusted returns and credit risk, in our opinion, properly compensate each other.
Positive Risk-Return Profile, Regardless of Rate Environment
The primary risk of core fixed income – duration, or rate risk – has always been a prevalent discussion point regarding the makeup of overall fixed income allocations. Given uncertainty about the direction of rates, understanding the potential risk and return for sub-asset classes in both rising and falling rate environments is critical.
As shown in the charts below, MBS have generally performed well relative to U.S. Treasuries and investment-grade corporate credit during both rising and falling rate scenarios over the past five years.
These trends demonstrate the potential for MBS to capture the upside from duration while having a yield component, which may limit the impact of rising rate periods. For investors seeking both risk mitigation and risk-adjusted returns, the diverse MBS market can potentially deliver both – regardless of rate environment.
The Role of Active Management in Fixed Income
MBS are a significant portion of the Bloomberg Barclays U.S. Aggregate Bond Index (27% as of September 30, 2019) and, therefore, are likely included as part of core fixed income strategies. But in our view, these strategies – particularly passive ones – may not always capitalize on the asset class’s diversification benefits through appropriate overweighting or underweighting. We believe active management is needed to harness the opportunities in MBS relative to other traditional fixed income sub-asset classes, especially when it comes to differentiating between agency and non-agency MBS.
As always, we think active management is especially important in fixed income, an area of the financial market that is large and diverse, creating opportunities for improved risk-adjusted returns. MBS are no exception.
1Source: SIFMA, as of 12/31/18
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
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