MBS Performance – Fact or Fiction?
This year has started off poorly for fixed Income. However, MBS has been highlighted by many as one of the few bright spots. We review MBS performance and look at factors for clues if this outperformance might continue.
Year to date, the Bloomberg Barclays U.S. MBS Index (MBS) has outperformed the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”) by ~250 bps.
However, this does not tell the entire story as the MBS index has a duration that has averaged ~2 yrs YTD while the duration of the Agg is ~6 yrs. From an excess return perspective, which adjusts for this duration differential, the MBS index’s outperformance versus the Agg is much smaller at only +30 bps. Also, comparing the MBS index to broad fixed income market indices with a similar short duration, MBS has actually underperformed the Bloomberg Barclays 1-5 Yr U.S. Credit Index (with a duration of 2.8 yrs), by 5 bps YTD.
Looking forward we see the case for continued MBS outperformance to be tricky at best. MBS OAS is currently at 10 bps, while the nominal spread (which does not account for the option MBS investors are short) is only 34 bps. Both measures are very low by historical standards, leaving little room in our minds for excess return beyond pure duration positioning. With the MBS market currently running into high levels of negative convexity due to higher rates, even that duration trade is being questioned. The recent move in interest rates has caused the MBS index duration to extend from under 2 yrs to 3.6 yrs in about a month. Any further interest rate sell off will continue pushing MBS durations higher, increasing the negative return potential from higher rates.
In summary, the recent performance of mortgages has been driven much more by duration differentials rather than excess outperformance from the asset class. At currently stretched valuations and elevated convexity risk levels, we do not see this outperformance being sustainable going forward. As is often with markets, peeling back the variables affecting performance, especially relative performance, can tell a different story than a headline.
We see individual security selection, and avoidance, as a key pillar of creating better risk reward opportunities for investors, not only in MBS but Investment Grade and High Yield credit as well.
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