Like most asset classes, mortgage-backed securities (MBS) have seen heightened volatility over the past two months as the world copes with COVID-19 and investors look to reduce risk. The MBS market managed to stabilize amid help from the US Federal Reserve, which purchased these and other securities in a broad support program. Franklin Templeton Fixed Income Portfolio Manager Paul Varunok offers his outlook for the MBS market in light of recent events.
What Are Mortgage-Backed Securities?
MBS are bonds that represent an ownership interest in a pool of residential mortgage loans. Homeowners make mortgage payments which are ultimately pooled each month and then “passed through” to MBS holders in the form of principal and interest cash flows. MBS are classified as either agency MBS or non-agency MBS. Agency MBS are created by one of three US government-sponsored agencies: Fannie Mae, Freddie Mac or Ginnie Mae (GNMA). Ginnie Mae bonds are backed by the full faith and credit of the US government and their credit is comparable to US Treasury securities. Fannie Mae and Freddie Mac bonds aren’t US government guaranteed, but they are under conservatorship of the US government and regulated by the Federal Housing Finance Agency. In contrast, non-agency MBS are issued by private entities, such as financial institutions. They are not guaranteed by the US government or any of the three government-sponsored agencies, and therefore carry a level of credit risk that is not present in agency MBS.
As COVID-19 spread throughout the global economy and financial markets, March 2020 was an exceptionally volatile month within the MBS sector. Yield spreads to similar duration US Treasuries in the sector widened the most since the global financial crisis (GFC) a decade ago, then sharply tightened after the US Federal Reserve (Fed) announced a massive support program to boost liquidity and provide stability across US government securities including agency MBS. The Fed’s active MBS purchases have been supportive of the asset class, and spreads have returned to a more normalized level, albeit still trading wider than pre-GFC levels.
Since the Fed’s announcement in March, the Federal Reserve System Open Market Account (SOMA) has absorbed a large share of market supply, purchasing US$617 billion as of May 7. We believe Fed buying will continue, keeping spreads well supported and range-bound.
The overall housing sector is facing opposing forces, which are leading to market uncertainty. While the low-interest-rate environment continues to be a tailwind and seasonal purchases have been strong, social distancing and other measures as a response to the COVID-19 pandemic could lead to lower housing activity.