Mortgage bonds look cheap to fund managers as Fed pauses

Asset managers like American Century Investments and Saba Capital Management are loading up on mortgage bonds to profit as the Federal Reserve increasingly appears to be close to ending its tightening cycle.  

Bonds have broadly surged in November after the latest U.S. consumer price index report showed essentially no changes in overall prices from the prior month, implying the Fed might be close to getting inflation under control. For weeks, investors had feared that rates would be higher for longer than expected, but now debt markets are boosting wagers on rate cuts next year. 

Less uncertainty about future movements of yields tends to be a positive for mortgage bonds. But while high-grade corporate bond spreads are close to their tightest level this year, mortgage bonds still look cheap by at least some measures. 

Spreads on Fannie Mae current coupon bonds, a proxy for mortgage bonds being created now, are about 159 basis points, or 1.59 percentage points above a blend of five- and 10-year Treasuries. That's far wider than the 10-year average of about 106 basis points, even if the spread has narrowed about 30 basis points since late October.    

"We do think that rates will be coming down, which will be a tailwind for the MBS market. Looking at the spreads, they're at close to historical wides, which is one reason why we're adding there," said John Lovito, the co-chief investment officer of global fixed income at American Century Investments in an interview earlier this month. "Over the last three to four months we've been adding to the point where we're overweight and we're going to go up to 5-10% over the benchmark."

Goldman Sachs Group Inc. says mortgage backed securities offer an attractive way to earn income as interest-rate uncertainty in the US falls. Janus Henderson is actively shifting capital away from corporate bonds, in particular junk debt, to boost its mortgage bond allocation, which makes up a third of its Multi-Sector Income Fund's fixed holdings. 

"Agency mortgages are very attractive with valuations at the cheapest they've been in more than a decade. We think they're fantastic and pre-payment risk is nearly non existent," said Phillip Gronniger, client portfolio manager for fixed income strategies at Janus Henderson, in an interview earlier this month. "Even if spreads don't tighten you're still clipping a decent yield." 

One reason for wide spreads: U.S. banks, traditionally one of the largest buyers of MBS, have stepped back from the market lately as their deposits declined earlier this year. Banks often fund their investments with deposits. 

Another key buyer of the securities is also cutting back on its holdings. The Federal Reserve was the biggest purchaser of mortgage bonds during the latest round of quantitative easing, but has effectively stopped buying them, shrinking its portfolio of the securities.

But even if demand is shrinking, there is a key positive for MBS now, namely that mortgage rates have risen so much over the last two years that few borrowers will have an incentive to refinance even if rates fall a bit from here. The risk that consumers will prepay their mortgages is low now, according to Sonal Desai, chief investment officer of Franklin Templeton Fixed Income. Prepayments hand principal back to investors at a time when yields are falling, cutting into gains on the securities.  

"You put these things together, and we are quite positive on the mortgage market. We are overweight," Desai said. 

In a note this month, Morgan Stanley strategists including Serena Tang and Vishwanath Tirupattur said that the bonds have potential to perform well. MBS spreads reflect weak sentiment now, and toward the second half of next year, sentiment will probably turn more positive, bringing modest tightening in spreads for the securities, the strategists wrote.   

Already Outperforming

Some of the outperformance that bond fund managers are anticipating has already taken place. MBS have broadly gained 4.2% in November through Friday, according to Bloomberg index data, compared with 2.6% for Treasuries. 

Those gains for mortgage bonds likely came as a relief to at least some bond fund managers who had already loaded up their portfolios with the securities. As Treasury yields kept heading higher, fund managers faced pressure to cut back on some of their MBS holdings, analysts at Citigroup Inc. said in a note dated Oct. 6.

But there is room for the bonds to continue performing better, according to Boris Peresechensky, a portfolio manager at Orange Investment Advisors. Bank deposits are showing signs of having leveled off, removing at least one obstacle to banks' buying, he said. A Federal Reserve report on Friday said that deposits in October rose 0.1% on a seasonally adjusted, annualized basis. 

The securities look cheap compared with some corporates, according to Boaz Weinstein, founder of Saba Capital.  

"With most 'experts' saying the Fed is done, agency MBS outright or vs BBB corporates is begging to be done," Weinstein wrote last week on X, the platform formerly known as Twitter. "I have it on in decent size."