Adam Hetts: Welcome to Global Perspectives, and glad to have Nick Childs and Tom Polus on today. Nick is a Fixed Income Portfolio Manager with a focus on securitized markets and Tom is a Securitized Products Analyst. This episode came about after a conversation we all had a couple of weeks ago at the office. You guys were pretty excited about what’s going on in MBS markets right now. There was a bit of hyperbole, to be honest, but I think you laid out a pretty strong case for MBS and laid it out clearly. Let’s go ahead and try to break it down again. And Nick, we’ll start with you. It hasn’t been a good year for any fixed income, but MBS has sold off worse than Treasuries. So, can you start just by explaining the unique pressures we’ve seen in MBS that sort of drove that disproportionate sell-off? And then, why this is probably a good thing going forward?

Nick Childs: Yes, absolutely. Thanks, Adam. You know, there are two main reasons. Number one revolves around the Fed’s asset purchase program. We call this quantitative easing, and this is what they did in COVID to survive the financial markets in terms of liquidity. And number two, interest rate volatility. There’s a common belief that, during the Global Financial Crisis, if the Fed had moved faster and larger, the crisis would have been shortened. So during COVID, they looked back at that experience and that’s exactly what they did. They moved very quickly and in a sizable fashion. And so that was all well and good, but their buying program, their asset purchase program, just went on too long. So what ended up happening is just a severe distortion in the mortgage market. So fast forward to today and what we would refer to as quantitative tightening, or the Fed ending their asset purchase program. Look, the opposite has taken place, and we’ve seen some of the worst excess returns in agency mortgages since the Global Financial Crisis.

In terms of interest rate volatility, mortgage rates have moved up at a magnitude and speed in which we haven’t seen since the early 1980s. Interest rate volatility in general, if you look at the Bank of America MOVE Index, which quantifies that, with the exception of two weeks in March of 2020, we haven’t seen this style of interest rate volatility since the Global Financial Crisis. And all of this is, frankly, just very negative for mortgages, right? Where interest rates are going, where mortgage rates are going is what drives fundamentals in mortgages. There’s no credit risk in mortgages. That’s why they’re counter cyclical. However, there is interest rate risk, which is effectively refinancing risk. That’s the major risk in mortgages, which allows for the spread and the spread product.

We’re in a Fed hiking environment, we don’t really know when inflation and how inflation comes down. But as we move towards the Fed’s perceived neutral rate, you know, naturally, interest rate volatility should come down.

Hetts: So MBS sort of had this disproportionately bad sell-off because not only did they have the rate volatility that all fixed income has seen year-to-date, which to your point, likely is going to go lower, not higher from here because it’s been such historically high-rate vol to date. But then MBS also specifically had these kind of supply increase concerns because of the quantitative tightening as you laid out. So now that those things are priced in going forward, there’s all the concerns about recession coming along. So how much of that do you think is priced in and, say, if those fears around recession are realized, how does MBS as an asset class perform during that kind of economic downturn or significant slowdown?

Childs: If you try to compare this period and if you do believe it is a supply issue given what the Fed’s done – and I think most would agree with that – you can look to the 2018/2019 period. Spreads are around 50% wider to averages seen in those periods. So I would argue that we’re very much priced in to very close to worst case scenario. In terms of what happens in a recession, the great thing about agency mortgages, and why I think investors use them structurally in their portfolio, is the counter cyclicality of the product. There is no credit risk. So in general that’s very helpful. And look, if history kind of even rhymes, the quantitative tightening which is effectively causing the dislocation today could end. And, in fact, if history repeats, dare I say the Fed moves back towards quantitative easing and actually starts buying the product all over again. So as I see it, should things get worse, this is actually a windfall for agency mortgages and not vice versa.

Hetts: That makes sense. We’ve got an investment-grade asset class and agency mortgages with a lot of bad news priced in. So then the other part of that conversation a couple of weeks ago was about how mortgage rates have moved up so historically quickly over this last six months and what that means for the MBS Index, and maybe how the MBS Index is sort of structurally flawed in a new way because of this rapid rise in mortgage rates. And so you guys are active managers in this space, so, Tom, can you walk us through [why], because of these recent moves, the ways that the MBS benchmark sort of feels broken to you guys right now and what the pitfalls might be of staying passive in MBS and not active?

Tom Polus: Yes, absolutely. Part of to look at where we are now is to kind of look at where we were in mortgage rates a couple of years ago. So that production had shifted to these lower coupons, so 2%, 2.5%. But given the raising rates we’ve just seen, mortgages are now being produced at 4.5%, 5% and 5.5% coupons. So the MBS Index right now is predominantly – 40% – 2% and 2.5%. That is no longer being produced, and the supply of those coupons has significantly been reduced by our quantitative easing over the last few years. The Fed now currently owns 60-some percent, if not a little more, of below 2.5% coupon. That’s a lot of the float that’s gone. So trading in those coupons doesn’t make a ton of sense. They don’t offer the same amount of carry; they’re trading extremely tight given the lack of float out there. So we shift where we can capture more carry, more spread, as well as take advantage of the higher rate volatility. So those are more negatively convex coupons. When vol comes down, we get more upside as that rate of volatility dissipates. And then at the same time, we can actually reduce that negative convexity in those coupons by picking prepayment stories that will do better in both a discount and, more predominantly, in a rally back, there’ll be a lot more upside in price appreciation.

Hetts: So the first thing you mentioned with the Fed owning, you said 60%, roughly, of the 2.5% and lower coupon loans out there, ties to what Nick laid out as one of the concerns, is all this increase in supply because of QT and the Fed not buying as many of those. But you’re saying, the big opportunity is in the higher-yielding loans that are more recent this year. So an active manager should be able to sidestep some of those supply increases that some investors are concerned about.

Polus: Yes, I mean the market overall has been concerned about, when they go into this quantitative tightening, not only do they stop buying specific coupons, which, they aren’t buying those lower coupons anymore because they’re no longer being produced. But if they need to sell, which is a big hot topic in the market, they are going to be predominantly selling 2% and 2.5%, which at this point, besides passive buyers, don’t have a lot of natural buyers. So that means that there’s going to be a lot more supply in those coupons that both the street and brokers as well as private money managers like ourselves might need to take down as the Fed sells. And if that’s the case, they need to be at wider spreads. So from where we are at this point, at these dollar prices, it makes more sense to be in the higher coupons the Fed are currently supporting, as well as, as they quantitatively tighten their portfolio, won’t get as much of an impact from future Fed sales.

Hetts: And then owning some of those higher coupon mortgages, you’re at closer to current mortgage rates in the market, so if rates did go back down for whatever reason, you’re a little more exposed to prepayment risk. But you mentioned there’s a bit of a toolkit as an active manager to manage down some of that prepayment risk. So what are some examples of types of loans that would have kind of below average prepayment risk?

Polus: So obviously, your largest prepayment risk is as rates move lower. So, right now we have mortgage rates close to 5.5%, if not higher. When we move back down to, say, 4.5%, a lot of these loans that were being produced right now are going to be refinanceable and, given the capacity that current originators still have from the last refi wave from 2020 to 2022, they will target those borrowers pretty aggressively. Typically those borrowers will be incentivized to refinance their loans. They can lower their payments, maybe they can even tap a bit of equity as rates go lower as well.

A lot of these lower loan sizes, these credit stories, will have less incentive to refinance, which means you’re going to be getting a higher cash flow or more carry over a longer term compared to if you were to buy a higher loan size, or just your run-of-the-mill sort of average borrower. They’ll be incentivized to refinance as rates move lower because they’re going to start seeing the dollar advantage that they’ll be saving on a monthly basis by refinancing to the lower mortgage rate.

Hetts: To recap then, flaws in the MBS Index and why it might be a broken benchmark of sorts right now is that the index is more skewed toward those lower coupon mortgages like the 2.5%, give or take, which, one, is lower yielding, and two, that’s where there’s more pressure from the quantitative tightening. And then also, it’s not skewed toward the higher coupon bonds – the more recent mortgages – which you’re explaining is the opportunity for an active manager. And be active and manage that prepayment risk the ways you explained, buying smaller loans or second homes, or just being active in the selection to manage down the risk of the prepayments along the way.

Polus: Yes, I think that summarizes it quite well.

Childs: One of the things I think folks don’t necessarily realize in the agency mortgage market is, 80% of buyers are not total return buyers. They’re not passive mortgage investors, they’re not active mortgage investors, they’re not total return investors. They’re banks, sovereign wealth institutions, and they’re focused around the most liquid area of the mortgage market. They’re not focused on deep discounted, 2% and 2.5%. And this is the real problem, and I think the issue in which the Fed is now presented in terms of, you know, how are they going to sell these assets? And you know, in the end, we’ll see how it works. But I think active has an advantage, at least today, versus passive, just given the starkness on what the current mortgage market today looks like versus what the index or outstanding mortgage market looks like.

Hetts: So that’s pretty good. I think we’ll wrap it up here. It’s a good recap of that conversation a couple of weeks ago. And thanks to our listeners for joining, and please don’t forget to like or comment. And if you’d like to hear more from Janus Henderson, you can find more Global Perspectives on Spotify or iTunes or wherever you listen. And of course, check out the Insights section of the Janus Henderson website. And thanks again. We’ll see you next time.