Agency MBS refers to the purchase of mortgage-backed securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac and Ginnie Mae.

How does this investment vehicle work in practice?

It is common for banks to sell a large percentage of their active mortgages to participants in the secondary mortgage market, including institutional investors, private firms, and governmental and quasi-governmental entities. These participants purchase mortgages from banks and bundle them into pools, a process known as securitization, to create financial securities that can be sold in the market to investors.

Each pool constitutes a security known as a mortgage-backed security (MBS), which represents an interest in the pool of mortgages. Like bonds, MBSs make coupon payments to investors. An agency MBS is an MBS issued by one of three quasi-governmental agencies: the National Mortgage Administration (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Now that we understand a little more about this asset class, we can ask ourselves a second question: Why is it attractive to invest in this type of asset today?

Yields have risen on Agency MBS as the Fed raised rates. MBS offer investment-grade (IG) credit quality and yield to maturity around 5%, according to the Bloomberg MBS Index. Agency MBS prepayment risk has decreased as many homeowners refinance mortgages in 2020-2021 at lower interest rates. In fact, approximately 78% of the index has coupon rates below 3.5%, meaning these homeowners are less likely to pay off those mortgages as current mortgage interest rates exceed 6.9%.

Under these conditions, MBS are likely to behave with greater certainty of cash flows. In this higher interest rate environment, lower rate homeowners are less likely to refinance and pay off their mortgages. Therefore, prepayment estimates are reduced and bonds are held outstanding longer at higher yields. With longer average lives, the average duration of the Bloomberg MBS Index has extended to 8.9 years in September 2023 from a low of 3.1 years in April 2020 (see chart).

In addition, the yield premium (spread) of MBS over U.S. Treasuries is near a 10-year high (see chart below). Over the past year, the Fed has stopped quantitative easing (QE) and is reducing its balance sheet (QT), which implies that it is slowly reducing its holdings of MBS. The Fed owns about 37% of all Agency MBS, which has led to their spread over Treasuries widening as the Fed withdraws from this asset.

With this large buyer out of the market, current investors are demanding a higher premium for holding MBS, so the spread has come to sit above 100 bps over yields on US Treasuries of similar duration. Even compared to corporate credit, the additional yield premium on MBS looks relatively attractive.

In summary, Agency MBS valuations are at historically cheap levels, mainly explained by technical reasons. Lhe strong fundamentals of this asset, which consist of a combination of yield potential, reduced prepayment risk, greater cash flow certainty, and relative attractiveness compared to other fixed income options, make Agency MBS an attractive investment at the current time.

Felipe de Solminihac

Investment Analyst