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US mortgage-backed securities – A positive outlook ahead of reflation

The outlook for US mortgage–backed securities (MBS) – a triple A rated fixed income asset backed by an implicit government guarantee – is upbeat. MBS are buoyed by a solid performance in 2020 and the prospect of continued buying under the Federal Reserve’s asset purchase programme as the US central bank extends its support for the coronavirus-hit economy.

At its policy meeting in December, the Fed said that asset purchases would continue until the economic recovery had made ‘substantial further progress’. While the Fed has offered few details on when it expected that to come about or which indicators it would look at, financial markets have focused on news on the progress on vaccination and possible timelines for the reopening of the economy.

Negative developments appear to be getting a lower priority in the eyes of the markets at this point. These include rising virus cases, hospitalisations and deaths. The higher transmission rate of the new variants of the virus has spurred new or tighter lockdowns. A number of US states have imposed additional restrictions on non-essential activity. Moreover, regulatory red tape and reluctance to get vaccinated in certain segments of the population have meant vaccination is advancing more slowly than what could be expected, adding to the factors that are seen delaying an economic recovery.

Encouragingly, the US Congress passed another large fiscal stimulus package in December, lending support to consumers and businesses, and the prospects for additional large-scale measures in the near term and for infrastructure spending later in the year have improved.

Reflation and a steeper yield curve

Democratic control of the White House and Congress administration could result in reflationary policies, pushing US Treasury bond yields higher. As the Fed’s policy rates remain anchored effectively at zero, the result would be a steeper yield curve.

Given that mortgage loan prepayment and refinancing are the key risks to MBS, a steeper yield would be a positive development. Low US mortgage rates make refinancing attractive for borrowers. Were interest rates to rise, more and more borrowers would find it less attractive to refinance. That in turn would mean lower prepayments from mortgage holders, which would give MBS investors more certainty about cash flows in an environment with a lower supply of new bonds. Under such circumstances, we would generally expect the spread over Treasuries offered by agency MBS to tighten.

Reflation would support US MBS, which is an asset earning a rare positive yield in global bond markets where trillions of dollars of assets are offering a negative return. For investors whose base currency is the euro, US MBS offer positive yields on a hedged basis. Given that German 10-year government debt currently yields around minus 0.50%, agency mortgage-backed securities compare very well.

We could see some yield-based buying of MBS by banks and money managers. Prepayments have plateaued for now, enhancing carry, and current coupon valuations look attractive. We prefer lower coupons where the carry has been strong via TBA dollar rolls. We also see opportunities in prepayment-protected specified pools with a focus on geography.

Also read:

US mortgage-backed securities, an oasis in the desert

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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