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Key Themes for 2023: Mortgage-Backed Securities and Preferred Outlook



Mortgage-Backed Securities and Preferred Outlook

Eric Bernum, Portfolio Manager

Mortgage-Backed Securities


2022 will go down in the history books as one of the toughest years on record for Agency MBS. Valuations coming into the year were on the tighter end of long-term ranges and were skewed by the effect of the massive Fed QE intervention in the market. Interest rate volatility spiked to decade highs and stayed elevated. The Fed flipped directions and began its QT run off for MBS holdings. Home price appreciation (HPA) began to roll over. And as icing on the cake, primary mortgage rates moved from the low 3% range to the mid 6%—a move of such magnitude not seen since the early 1980s. These combined factors led to extremely poor excess returns for MBS in 2022.

Looking forward to 2023, the headwinds appear to remain daunting, though there are some green shoots of optimism. However, given the wide range of mortgage securities following the 2022 valuation and yield moves, MBS has clearly become a much more diversified asset class as certain outcomes will impact different mortgages in almost completely diametric ways. This amplifies the importance of individual security selection in driving returns.

The MBS market will continue to face headwinds into 2023 caused by stickier than expected interest rate vol, technical headwinds from the Fed QT program, and further pressure on home prices, affordability, and refinanceablity. All of this is exaggerated by the year-end rally in MBS valuations, which left the asset class looking far more average from a valuation perspective compared to even four weeks prior.

On the positive side, the biggest factor in favor of MBS is that interest rate volatility remains above long-term averages, so a mean reversion in this would be a significant tailwind. Refinancing activity will be essentially non-existent if mortgage rates stay near current levels, which will reduce the shorter-term impact of negative convexity on return outcomes. Additionally, using historic measures that admittedly come from very different market environments, MBS now looks fair to marginally attractive versus Investment Grade Corporates—especially as market concerns around credit risk and the potential for a recession look to be a major focus in 2023.

After acknowledging the factors both for and against MBS, we are left biased to the negative. Starting with a foundation of “Don’t fight the Fed”, we think that any sustainable decline in interest rate volatility and a more positive technical backdrop for MBS is contingent on deceleration in the Fed’s QT efforts. With valuations not being attractive enough to entice large scale buyers to offset the Fed’s runoff, we think that technicals will remain a large headwind for the asset class.

We are cognizant that the speed and magnitude of 2022 MBS valuation changes were far beyond normal. We would expect this to continue into 2023. Similar to 2022 when we purchased substantial amounts of MBS exposure as valuations moved to more attractive risk-adjusted levels in late Q3/early Q4, we expect our view may change rapidly if valuations move to levels reflecting more of the headwinds we foresee. Additionally, the vast divergence of underlying MBS characteristics in this new environment and the disparate outcomes make security selection and avoidance of vital importance moving into 2023.



Over the course of 2022, we saw preferred security valuations move substantially higher. To begin the year, generic preferreds were yielding in the mid to low 4% range. Exiting 2022, the generic yield on preferreds had reset to the mid to low 6% range. Moreso than any other Fixed Income asset class, investment outcomes for preferreds are driven by unique security specific characteristics. So, while it is much harder to speak to index yields given the number of assumptions required, it’s clear there is significantly more yield available in the preferred market compared to one year ago. To illustrate this, on October 19, 2021, Bank of America issued a fixed for life preferred at 4.25% that is not callable until 2026. As of early December 2022, this bond was trading at approximately 70 cents on the dollar and yielding in the low 6% area.

Many pundits have pointed to this dramatic increase in preferred yields as an attractive area for investors. However, take a step back from headline yields, and we find the conclusion is more complicated than it seems. Similar to the debate in the Investment Grade (IG) and High Yield (HY) markets, the attractiveness of preferreds is skewed depending on whether one views valuations on a yield or spread basis. Using the Bank of America example above, the yield on the security is just under 200 bps higher since issuance. However, during the same time period, the yield on long duration U.S. Treasuries (UST) are roughly 160 bps higher. This means the implicit spread of the preferred vs long-duration USTs is approximately 30 bps wider on the year. Viewed through that lens, it can be argued that generic preferreds have outperformed IG credit, which is counterintuitive given the far higher sensitivity of preferreds to changes in economic and corporate fundamental outlooks.

Additionally, when the current yields of preferreds are compared to the Bloomberg U.S. Corporate Bond Index (IG Index) and the Bloomberg U.S. Corporate High Yield Index (HY index) yields, the attractiveness of the asset class doesn’t seem attractive. The IG index currently yields in the low 5% area, while the HY index is in the mid to high 8% range. With corporate fundamentals set to face headwinds into 2023, an approximate 100 bps pick up to buy preferreds compared to IG or an approximate 250 give in yield compared to HY doesn’t appear overly interesting from a high level.

Despite macro valuations on preferreds that may not seem that appealing, as was mentioned initially, the preferred asset class is one where individual security characteristics drive an outsized proportion of returns compared to other fixed income asset classes. With this backdrop, we believe there will be continued attractive investment opportunities in the preferred universe if one is willing to do the requisite extensive research to help identify these unique securities. As we have seen repeatedly in 2022, large divergences in individual performance have been driven by an individual preferred’s callability, potential coupon resets, floating or fixed rate nature, convexity profile, loss of capital treatment, and attractive repurchase opportunities for the issuer. We believe our deep fundamental-focused credit research process aligns with the ability for security selection to be an outsized driver of returns within the preferred universe.

To read our full 2023 Outlook, click here




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