US MBS – Showing resilience in the face of coronavirus fears

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Coronavirus-related fears have gripped the world, driving leading equity markets into bear market territory, as markets drop by more than 20% from the high reached on 19 February, and pushing benchmark US bond yields to historic lows.

After a slow start, central banks and global policymakers are now in the early stages of a coordinated response to the economic implications of the pandemic. We expect a combination of both monetary policy measures from central banks and fiscal stimulus measures from elected officials.

Lower rates and the return of QE?

We expect the Federal Reserve to cut the fed funds rate further, starting at the 18 March FOMC policy meeting. Further cuts will likely move the rate closer to the zero bound.

As a result, unconventional policy tools could come back into play including quantitative easing (asset purchases; QE) through balance sheet expansion. Currently, the Fed’s balance sheet as it relates to mortgage-backed securities (MBS) has been shrinking: about USD 20 billion in MBS runs off each month.

QE might target agency MBS

We believe this would be one area of the fixed income market for the Fed to reconsider for QE beyond further rate cuts. Stopping the run-off would add USD 20 billion in demand for MBS and reverse a source of monetary policy tightening.

Fixed income risk assets did poorly at the start of the year, with US investment-grade corporate bonds earning a negative 4.27% excess return, US high-yield credit -5.67%, and emerging market USD debt -5.05%. US agency MBS with its high credit quality and government backing has been a safe haven asset class, faring much better with an excess return of a more modest -1.04%.

MBS attractions stand out

We see the virus-driven growth slowdown continuing to have a much greater impact on corporate credit than on agency MBS. Ratings downgrades and default risk are rising and the risk premiums can continue to be pushed higher.

Relative to corporate credit, agency MBS offers a relatively safe yield, superior credit quality and far better liquidity and transparency. The current coupon nominal spreads on MBS are as wide as they have been in three years. Investment-grade corporate bond spreads had narrowed too far, and although they have widened recently, we believe they may need to widen by more.

Exhibit 1: Current coupon nominal spread and OAS – graph shows the difference (spread) between the yield on Fannie Mae’s 30-year bond (FNMA 30-year) and the 2-year US Treasury bonds (front UST) and the option-adjusted spread (OAS) between the FNMA30 and Libor

Exhibit 2: Nominal spread of investment-grade (IG) corporate bonds over US Treasury bonds, and the spread of the FNMA30 bond over front-end US Treasury bonds

Source for both exhibits: JPMorgan; data as of 10 March 2020

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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.

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