Agency MBS enters 2026 characterized by steady growth, range-bound interest rates, and subdued volatility. While market conditions remain favorable, the margin for error has narrowed. Net supply is increasing through mortgage production tied to home purchases rather than rate-driven refinancing, while demand remains selective at current valuations. With limited margin for error, we believe outcomes are increasingly driven by borrower behavior, collateral composition, and disciplined execution.
Mortgage rates are expected to remain within a 6.00% to 6.50% range, underpinned by stable Treasury yields and low volatility. With the average effective mortgage rate near 6.90% in 2025, incremental improvements in affordability may modestly increase housing turnover, but are unlikely to catalyze a material refinancing cycle. Home prices are expected to remain broadly stable, with national appreciation between flat and 2%, alongside greater regional dispersion. This configuration echoes the broader 2026 investment landscape: fundamentals establish the downside boundary, while valuation and structure govern upside potential.
Borrower behavior has evolved. Those with recently originated mortgages, particularly those carrying rates of 6% or higher, are exhibiting faster response times to incremental rate movements. Advances in origination technology and shorter closing timelines have amplified prepayment sensitivity. These dynamics do not introduce systemic risk, but they can heighten cash-flow sensitivity to rates, reinforcing the importance of convexity management and rigorous collateral analysis.
Supply is projected to increase in 2026, though its composition remains more consequential than aggregate volume. New issuance continues to be driven predominantly by purchase activity and steady production rather than refinancing, as the lock-in effect remains a defining constraint on borrower behavior. Nearly half of borrowers continue to hold mortgage rates at or below 4%, limiting refinancing even in the event of modest rate declines. Housing activity is normalizing rather than accelerating, with existing and new home sales expected to grow 3–5%, while remaining well below prior cycle peaks. This backdrop supports measured mortgage production and relatively predictable borrower incentives.
Policy sensitivity adds an additional dimension to market structure. Housing affordability remains a highly visible political issue, and Agency MBS continues to function as a primary transmission channel for policy signaling. While recent commentary reflects a growing focus on easing financial conditions, the translation of policy intent into materially lower mortgage rates remains uncertain. The scope and durability of any initiatives remain uncertain, but markets have already adjusted pricing to reflect this sensitivity, underscoring the role of sentiment and positioning alongside underlying fundamentals.
Demand in 2026 remains disciplined and increasingly shaped by structural considerations. Banks continue to allocate conservatively under regulatory constraints, directing deposit growth and balance-sheet paydowns primarily toward Treasuries and select structured products rather than traditional MBS. As a result, non-bank investors — particularly money managers — continue to serve as the marginal price setters. Although many reduced their allocation to MBS in 2025, positioning remains modestly overweight to the index. With stable inflows, incremental supply is expected to clear without a material spread concession. In our opinion, this equilibrium supports valuations while constraining the potential for broad-based spread compression.
Valuations reflect this balance. MBS spreads are near multi-year tights, leaving limited scope for further tightening absent a clear catalyst, though nominal levels remain reasonable in the historical context. In our view, low-rate volatility should be supportive of price stability rather than repricing. As across other spread sectors in 2026, excess returns may be increasingly realized through security selection rather than broad exposure.
In this environment, portfolio outcomes hinge more on construction than on directional conviction. Our analysis emphasizes call protection, disciplined management of negative convexity, and the prioritization of durable cash flows across pool types. We evaluate relative value across higher-coupon pools with strong call protection, generic exposure in the belly of the coupon stack, and structures designed to retain duration during rate rallies. We also assess lower-coupon pools and select CMO structures with more predictable cash flow profiles as part of a comprehensive portfolio construction process.
In 2026, our view for Agency MBS reflects the broader investment landscape: fundamentals remain stable, valuations offer limited cushion, and performance is increasingly driven by borrower behavior and collateral composition. In this environment, discipline matters—participating where risk-reward is adequately compensated and avoiding where it is not. For Smith Capital Investors, our North Star does not waver: Participate and Protect.
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