This article is part of the latest Trends and Opportunities report, which seeks to provide therapy for recent market shocks by offering long-term perspective and potential solutions.

This year’s dramatic mortgage rate rise has led to higher-coupon mortgage bond opportunities for investors, with a compelling yield cushion to protect against future volatility.

YTD Recap

• The unprecedented sell-off across fixed income has been particularly pronounced in mortgage-backed securities (MBS), which have underperformed Treasuries while simultaneously seeing spreads widen more than investment grade credit.
• Quantitative tightening (QT) is driving this repricing, leading to an increase in MBS supply, hurting sentiment, and creating heightened uncertainty around the asset class.
• When mortgage rates plummeted in 2020 and 2021, record numbers of borrowers refinanced at historically low rates. This year, rates have risen sharply and swiftly to over 5.50%

Selloff has Hurt MBS More than IG Credit

Source: Bloomberg, Janus Henderson Investors. As of 8/31/22.

Outlook

• This year’s dramatic mortgage rate rise has led to higher-coupon mortgage bond opportunities for investors, with a compelling yield cushion to mitigate against future volatility.
• With 72% of outstanding mortgages sitting at rates below 3.50%, prepayment risk has declined dramatically, mitigating what is traditionally a dominant risk in MBS investing.
• While the potential for additional volatility from QT still exists, we now believe that spreads in the sector are broadly mispriced, offering noteworthy total return opportunities.

Opportunity Favors Active Management

Source: Bloomberg as of 8/31/22

PCS Perspective

• MBS > Agg: Like the broader U.S. Aggregate Bond Index (Agg) benchmark, MBS can serve as a ballast in investor portfolios during times of volatility. However, due to this year’s dramatic spread and mortgage rate movements, MBS now offer higher yield with similar or lower duration risk than the U.S. Agg.
• Active > Passive: Compared to passive MBS allocations, which are often concentrated in older, lower-yielding mortgages more affected by QT, active allocations in MBS may be warranted for two important reasons:
  1. Active management can help increase yield and mitigate risk from QT by allocating to newer, higher-coupon mortgages.
  2. Through security selection, active management seeks to mitigate prepayment risk; this is particularly important with newer, higher yielding mortgages that are closer to market rates.

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