Managing MBS investing is growing more complex by the day, placing risk concerns at the forefront for the buy-side and redefining the MBS landscape. But despite all the complexity, a recent Coalition Greenwich study finds that 67% of buy-side fixed-income professionals are poised to increase their MBS volume in 2024.
There are distinct macro and market factors that are fueling the pronounced shift we’re seeing in buy-side investment behavior in the MBS space. Below we touch on three leading factors, as reported by Greenwich Coalition in their recent report: Managing Mortgage Market Risk Becomes More Complex.
Factor 1: Heightened Rates
In early 2020, the COVID-19 pandemic created numerous strains in the market, resulting in rising costs for goods and services—much of which stemmed from tightness in the labor market. Sharp inflation growth precipitated higher benchmark rates at the same time as mortgage stimulus was being withdrawn by the Fed. What’s more, the average 30-year mortgage rate jumped nearly 400 basis points in a 10-month time frame, from 3.22% in January to 7.08% in October 2022. At the time of writing this blog post, the average 30-year fixed mortgage interest rate remains fairly high at 7.06%.
In terms of economics, some market participants feel the soft-landing narrative is still in play as recent U.S. GDP prints and jobs reports come in strong. In Q3 2023, the GDP grew at 4.9% annually, outperforming the expected 4.7%. The fourth quarter of 2023 saw lesser, but still significant GDP growth at 3.3%.
Mortgages have been an interesting space to watch because volatility has been causing spreads to widen compared to corporate bond spreads. The Fed’s aggressive tightening and uncertainty about the potential timing for rate cuts will continue to fuel volatility, and more trading and activity is expected to follow.
Factor 2: Challenged Liquidity
Another force driving the transforming MBS landscape is the need for greater liquidity, evidence of which can be seen with “To-Be-Announced" securities (TBAs). TBAs are a type of MBS representing a forward contract for the purchase or sale of agency MBS that have not yet been issued or specified.
In normal market conditions, there are typically three actives in the 30-year TBA space predicated on a current or prevailing coupon. As a consequence of the spike in rates, several changes to the current coupon resulted in about eight to nine tradable coupons circulating in the TBA market that dealers must stand ready to price and risk-manage on behalf of their clients. While buy-side investors may be ready to take on additional trading, the effects of numerous changes to the current coupon, bank risk-management practices, and market uncertainty and volatility have resulted in challenged liquidity.
Despite the challenges, funds and advisors remain committed to MBS investing. Although sell-side firms have been more reluctant to provide liquidity as a group, the path toward more electronification may be the answer to overcoming current conditions.
Factor 3: Lack of Market Transparency
There’s no denying that rapidly rising rates have had a knock-on effect on mortgage indices. These indices once comprised of 1.5%–3.5% coupons have now shifted to include coupons north of 6% in less than a year. Both index providers and investors struggled to keep pace with the speed of increased rates. As mortgage rates soared, current coupons and convexity in the market weren’t reflected right away. These conditions created opaqueness in a market that is typically more transparent, leading to pricing issues and heavier reliance on modeling and evaluative analytics that may also suffer from data inaccuracies.
The current environment may lend itself well to active management of bond portfolios, given a wide variety of mispriced instruments and very wide spreads compared to the last quantitative easing period. While high rates lead to a much more challenging environment in some ways—particularly in areas like commercial real estate—the “right” bets could see managers outperforming the index.
Looking Forward
It’s clear that the latest dynamics in the mortgage market have created challenges not seen since the financial crisis, as the need for more robust trading, risk and portfolio management becomes more apparent. As a result, buy-side investment managers are turning to improved data sources, advanced technology and analytical tools to successfully navigate the MBS market ahead of an anticipated bump in investment and trading as we move further into 2024.
Complimentary Greenwich Report Download
For a deeper dive into how today’s fixed income investors are navigating MBS amidst a volatile marketplace and record-high rates, download this detailed report by Greenwich Coalition: Managing Mortgage Market Risk Becomes More Complex.
