The market for U.S. government mortgage-backed securities remains deeply liquid despite signs that trading conditions have weakened, according to researchers at the Federal Reserve Bank of New York.
The difference between MBS bid and ask prices, which is known as a spread and is considered one of the most direct measures of liquidity, has been relatively stable since 2011 when the Financial Industry Regulatory Authority first began tracking the transaction data, researchers Rich Podjasek, Linsey Molloy, Michael Fleming and Andreas Fuster wrote in the latest part of a series of reports aimed at assessing liquidity across financial markets.
The stability of transaction costs should be a good sign for investors, who've long considered the market for agency mortgage securities to be the most liquid after Treasury bonds.
What's changed is that transaction volumes have plummeted, which can indicate a weakness in liquidity. The nosedive has occurred at the same time the Fed, which doesn't trade its investments, has become the single largest buyer of agency MBS. As the U.S. central bank has acquired $1.7 trillion of MBS since 2008 under its quantitative easing program, average daily trading volume plunged by more than 40%, data from the Securities Industry and Financial Markets Association show.
Transaction volumes have decreased due to "myriad factors," the researchers wrote, citing more regulation, a decline in issuance and a rise in investors who don't trade the securities.
"Liquidity is still strong," said David Finkelstein, chief investment officer for agency and residential mortgage-backed securities at Annaly Capital Management Inc., which calls itself the world's largest mortgage real estate investment trust with some $75 billion in assets under management. "Though it's slightly dissipated because of the presence of a passive investor, i.e., the Fed."
Policy makers are tracking the trading conditions to see how the market has changed in recent years. The New York Fed said in October that liquidity in corporate bond markets was "ample."
Some investors, however, have argued that dealers are becoming less willing to make markets and that liquidity has suffered as a result. Barclays and Deutsche Bank, for example, are among mortgage-bond dealers scaling down their activity as the Fed's presence in the market makes it more difficult to turn a profit.
The Securities and Exchange Commission and the Financial Industry Regulatory Authority have made trading in fixed-income markets a priority in the past year, as asset managers including Pacific Investment Management Co., BlackRock Inc. and AllianceBernstein Holding urged regulators to focus on liquidity in debt markets. The money managers sought to address what BlackRock called a "broken" market in 2014.
Mortgage-backed securities are the primary funding source for U.S. mortgages. A serious decline in liquidity could lead investors to demand premiums on the bonds, which would ultimately raise borrowing costs for U.S. home buyers, the researchers said.
"It will be interesting to monitor liquidity conditions in this market as monetary policy is normalized," the researchers wrote.
