Like most major segments of the bond market outside Treasuries, mortgage-backed securities (MBS) experienced increased market stress as global COVID-19 containment efforts accelerated. And, like most major segments of the bond market, market stress declined after the Federal Reserve (Fed) stepped in, which included renewed MBS purchases.
Despite the market volatility, MBS were relatively resilient. As shown in the LPL Chart of the Day, while MBS spreads did widen the most since the financial crisis in March, they have returned to close to their long-term average and were not nearly as volatile as corporate spreads.
“MBS offer a middle ground among investment-grade bond sectors, with agency MBS providing more income than Treasuries but less credit risk than investment grade corporate bonds” said LPL Financial Senior Market Strategist Ryan Detrick. “The current environment comes with unique risks, but Fed buying and potential support for servicers if additional signs of stress appear should help see the sector through.”
In addition to Fed support, low interest rate sensitivity, and the possibility of further spread compression based on prior periods of quantitative easing, the income MBS generate also attracts investors. According to Bloomberg data, the average coupon for the Bloomberg Barclays US MBS Index is 3.5%, which compares favorably to 3.9% for the Bloomberg Barclays US Corporate Index, and is superior to the 2.2% of the Bloomberg Barclays US Treasury Index.
MBS also have their weaknesses. They can be more challenging to understand than other quality bond sectors because mortgage payments aren’t necessarily steady. Mortgage holders’ ability to accelerate (or slow down) prepayment, including refinancing, has some negative impact on how MBS respond to rate changes compared to other type of bonds.
There is also some concern about the impact of mortgage forbearance as part of the government’s response to COVID-19. MBS servicers, who receive the mortgage payments and channel them toward the appropriate investor, are still required to make MBS payments to investors, even when an underlying mortgage payment is not made. They do have reserves to cover those payments. However, with forbearance levels currently over 7% and potentially rising, there are concerns that covering the payments may not be sustainable. While there is resistance to providing loans to servicers right now, the Fed and federal government have supported all key areas of bond markets experiencing increased stress thus far. We believe that, if needed, they would step in here as well.
This continues to be a challenging time across the economy. With the Fed buying MBS again, prepayment risk declining, and still some potential for spread narrowing based on prior periods of Fed quantitative easing, we have upgraded our view of MBS and believe they can play a reasonable lead role in a diversified bond portfolio for suitable investors.
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