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.

 

Let’s talk – Smith Capital Investors  

 

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The opinions and views expressed are as of the date published and are subject to change without notice of any kind and may no longer be true after any date indicated. Information presented herein is for discussion and illustrative purposes only and should not be used or construed as financial, legal, or tax advice, and is not a recommendation or an offer or solicitation to buy, sell or hold any security, investment strategy, or market sector. No forecasts can be guaranteed, and the author and Smith Capital Investors assume no duty to and do not undertake to update forward-looking predictions or statements. Forward-looking predictions or statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking predictions or statements.

Any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity and is not tailored to the investment needs of any specific individual or category of individuals. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to changes at any time due to changes in the market or economic conditions. The information presented herein has been developed internally or obtained from sources believed to be reliable; however, neither the author nor Smith Capital Investors guarantees that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.  It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio.

Past performance is no guarantee of future results. As with any investment, there is a risk of loss. Investing in a bond market is subject to risks, including market, interest rate, issuer, credit, inflation, default, and liquidity risk. The bond market is volatile. The value of most bonds and bond strategies are impacted by changes in interest rates. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens. High yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Please consider the charges, risks, expenses, and investment objectives carefully before investing. Please see a prospectus, or, if available, a summary prospectus containing this and other information. Read it carefully before you invest or send money. Investing involves risk, including the possible loss of principal and fluctuation of value.

All indices are unmanaged. You cannot invest directly in an index. Index or benchmark performance presented in this document does not reflect the deduction of advisory fees, transaction charges, and other expenses, which would reduce performance.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission from Smith Capital Investors.

Smith Capital Investors, LLC is a registered investment adviser.

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