Agency MBS Performance in a Rising Rate Environment

Transcription

1 Agency MBS Performance in a Rising Rate Environment Katie Herr, Investment Specialist October 2015 INTRODUCTION During the course of this year, the start of policy normalization by the Federal Reserve has often appeared imminent, only to be pushed further out into the future as disinflationary impulses from abroad and tighter financial conditions have led policymakers to take a more cautious approach. We are again in such a period, with investors debating whether the economic outlook will allow for the start of policy normalization later this year. In conjunction with a slowdown in emerging market economies and China, this continued policy uncertainty has contributed to higher volatility across financial markets. A second source of uncertainty relates to how various asset classes will perform as monetary policy tightens. In this piece, we take advantage of yet another delay in policy liftoff to explore how a particular asset class, agency mortgage-backed securities (MBS), can be expected to perform once interest rates rise. We also examine how adjustments to the size and composition of the Federal Reserve s balance sheet during normalization may impact MBS performance. Overall, we conclude that increased certainty over MBS cash flows in a rising rate environment tends to lead MBS to outperform comparable-duration Treasuries. In addition, in this next hiking cycle MBS should benefit from Federal Reserve communications that stress a shallow path for policy rates over the next several years. Finally, we expect that a gradual shrinking of the Federal Reserve s balance sheet through controlled run-off rather than outright sales will minimize the potential for shocks to longer-term interest rates and support MBS performance. WHY AGENCY MBS TEND TO OUTPERFORM WHEN RATES RISE Unlike most fixed income instruments, which have bulleted cash flows where the timing of the principal return is known with certainty, the cash flows and timing of principal return of an agency MBS is uncertain. MBS have a unique characteristic prepayment risk which is responsible for this uncertainty. Investors in MBS receive extra compensation for taking on this cash flow uncertaintly (currently +100 basis points in yield). Prepayment risk represents the risk that households holding the mortgages underlying an MBS security decide to pay off their mortgages early. Prepayments can arise from one of four sources: 1. Refinancing: When a homeowner replaces his or her original home loan with a new loan to take advantage of lower mortgage rates. 2. Relocation: Taking a job in another region, for example, may require selling an existing home and prepaying the mortgage from the proceeds. 3. Trading Up/Down: A family may seek a larger or smaller home as their circumstances, such as family size or wealth, change. Sale of the current home leads to a prepayment of the associated mortgage. 4. Default: If the homeowner defaults, the Government-sponsored enterprise (GSE) pulls the mortgage from the MBS pool and pays the full outstanding principal amount to the MBS investor. The last three moving, trading up/down, and default are relatively static over time at around 5-6% of all outstanding MBS. That is, absent any economic incentive, 5-6% of a mortgage pool will pay off annually for these reasons. Refinancing, on the other

2 Agency MBS Performance in a Rising Rate Environment October hand, is much more volatile and driven largely by the interest rate environment. Mortgage holders in the US are able to refinance their mortgage at any time and typically with no penalty, so that when rates fall dramatically, more mortgage holders choose to refinance their homes. When homeowners refinance and pay off their existing mortgages, the MBS pool that contains these mortgages receives the proceeds from the refinancing. This presents two challenges for MBS investors. First, when MBS are trading above par 1, the repayment of principal will be less than the traded value of the MBS, resulting in a loss for the MBS holders. The second challenge for MBS investors is that the cash received due to prepayments would likely be reinvested at lower market yields than the initial investment. Given these challenges, MBS investors benefit from a gradually rising rate environment, as the increase in rates reduces prepayment risks and decreases cash flow uncertainty. This relationship between rate changes and cash flows highlights that when rates rise from very low levels, MBS exhibit less price sensitivity than fixed income assets without embedded prepayment risk. HISTORICAL PERFORMANCE IN RISING RATE ENVIRONMENTS The chart below illustrates the historical performance of agency MBS during calendar years when 10-year Treasury yields rose. Between 1988 and 2014 there were 10 such instances. Agency MBS had negative total returns in only two of the 10 years 2. Both of these episodes were marked by monetary policy surprises (for example the 2013 Taper Tantrum) and a significant increase in fixed income market volatility. Notably, duration-adjusted excess returns over Treasuries (the blue bars in the chart) remained positive in both of these instances. In fact excess returns were positive in nine of these 10 instances of rising rates. Agency MBS Performance During Rising Rate Environments 12% 10% 8% 6% 4% 2% 0% -2% -4% Excess Return Contribution from Duration Total Return YoY 10-year US Treasury Change (bps) HOW DO AGENCY MBS PERFORM DURING US MONETARY POLICY TIGHTENING CYCLES? Given expectations that the Federal Reserve will begin a gradual process of policy normalization in the coming months, in this section we zero in on agency MBS performance during prior tightening cycles. The two charts below show cumulative excess and total returns, respectively, for the MBS market for the 1994, 1999 and 2004 tightening cycles. Returns are shown for the period beginning three months before the first policy rate increase, since policy moves tend to be anticipated by the market. Cumulative Total Returns 3 Mmonths before First Rate Hike = Feb Feb 1995 Hike Cycle Jun Jun 2006 Hike Cycle Cumulative Excess Returns 3 Mmonths before First Rate Hike = Months from Start of US Federal Reserve Rate Hikes Jun May 2000 Hike Cycle Feb Feb 1995 Hike Cycle Jun Jun 2006 Hike Cycle Months from Start of US Federal Reserve Rate Hikes Jun May 2000 Hike Cycle 1 As of September 30, 2015, 99% of the MBS universe is priced above par. On this date, the average dollar price of the Barclays US MBS Index was $ Barclays US MBS Index

3 Agency MBS Performance in a Rising Rate Environment October From this exercise, two important observations emerge. First, within a few months after the start of tightening, the agency MBS market registered positive excess returns over US Treasuries 3 in all three episodes, and generally continued to outperform over the full cycle. Regarding total returns, the 1999 and 2004 cycles saw modestly negative performance initially. However this reversed within three months and across the full span of both cycles, MBS registered positive cumulative total returns. In contrast, MBS registered negative cumulative total returns for an extended period during the 1994 cycle, although even in this episode cumulative returns turned positive within a year, and were on par with returns seen during the two other cycles. There are important reasons why the 1994 cycle will likely be a poor guide to total MBS returns in the next tightening cycle. First, the 1994 cycle saw a relatively rapid initial increase in the target federal fed funds rate, of 175 basis points over the first six months of tightening. In contrast, anticipated Fed tightening over the next several years is expected to be very gradual in light of remaining crisis headwinds and global factors that are keeping inflationary pressures in check. Second, the pace of rate increases in 1994 surprised market participants, and prompted many MBS investors, including the GSEs, to hedge the extension of MBS duration by taking short positions in Treasuries. This hedging activity led to further increases in 5- and 10-year Treasury yields and losses across many fixed income asset classes, including MBS. This hedging dynamic should not play a meaningful role in the next tightening cycle. This is because today one of the largest holders of MBS, the Federal Reserve, does not dynamically hedge their mortgage holdings. And Fannie Mae and Freddie Mac have also ceased dynamically hedging their MBS since entering into government receivership in 2008 and subsequently running down their mortgage portfolios. The 2004 tightening cycle may serve as the most useful blueprint for MBS performance once the Federal Reserve begins to raise rates. Similar to 2004, the Federal Reserve continues to provide very active guidance on the likely path of interest rates, which could serve to keep fixed income volatility low. Also, if a global savings glut served to keep long-term interest rates low throughout the previous tightening cycle, there are reasons to expect longer-term rates to remain relatively low at least early on in the next cycle. First, a low-growth and low-inflation outlook implies a very low terminal federal funds rate during this cycle. In addition, highly accommodative policy abroad, including ongoing quantitative easing by the ECB, should support global private sector demand for US fixed income. FEDERAL RESERVE BALANCE SHEET ADJUSTMENTS LIKELY TO BE GRADUAL Past tightening cycles provide some useful insights into the outlook for MBS once policy normalization begins. Still, it is important to be aware of meaningful differences in the monetary policy framework, and how these differences may or may not affect markets. In particular, the Federal Reserve has indicated that it plans on reducing the size of its balance sheet as part of policy normalization. On the surface, a reduction in Federal Reserve MBS holdings would appear to be a significant headwind to performance going forward. However in practice the impact should prove to be limited as balance sheet reduction will be extremely gradual. Committee members have repeatedly signaled that they do not anticipate selling Treasury or MBS holdings, and that a reduction in the size of the balance sheet would be achieved by ending the policy of reinvesting proceeds on maturing and prepaying securities. As part of this gradual approach, a change to reinvestment policy would not commence for at least three months after liftoff. And even when the policy is changed, the Committee is very likely to phase in an end to reinvestments very slowly, stretching the process of balance sheet normalization over a roughly five-year period. This is because the Committee seeks to ensure that right-sizing the balance sheet does not lead to an undue tightening of financial conditions that would jeopardize its employment and inflation goals. This over-arching objective will ensure that the reduction in the size of the balance sheet occurs in a gradual and controlled manner, limiting the scope for balance sheet policy to adversely impact fixed income markets, MBS included. CONCLUSION A review of recent history reveals that in rising rate environments, including monetary policy tightening cycles, a reduction in prepayment risk has supported absolute and relative MBS returns. We anticipate this relationship to hold in the next tightening cycle, barring any policy communication errors or an inflation overshoot. In addition, clear signals from the Federal Open Market Committee (FOMC) about a shallow path for policy rates should serve to limit uncertainty about the interest rate outlook, while a gradual pace of Federal Reserve balance sheet reduction will mitigate the risk of a sharp increase in net MBS supply. Finally, limited active hedging by MBS holders relative to prior tightening cycles represents an important structural shift in the market that removes a potentially destabilizing source of volatility from the market. The agency MBS asset class offers high quality, superior risk adjusted returns, steady income in a stable rate environment and the opportunity to benefit from a rising rate environment as prepayment risks fall. Fixed income investors concerned about rising rates should consider diversifying portfolios by adding agency MBS. 3 Barclays US MBS Index, sourced from Barclays Live.

4 Agency MBS Performance in a Rising Rate Environment October Biography Katie Herr Investment Specialist Inflation-Linked Bond and Structured Securities Portfolios Fischer Francis Trees & Watts Katie is an Investment Specialist on the Global Rates and Structured Securities teams at FFTW, a subsidiary of BNP Paribas Investment Partners. She is responsible for representing FFTW s single-sector fixed income capabilities and for the communication and commercialization of inflation-linked and structured securities strategies. Katie joined our company in 2014 and is based in New York. Prior to joining us, Katie was a Product Strategist on the Institutional Multi-Sector Portfolio team at BlackRock. In that role, she was responsible for representing the team in client meetings and marketing the strategies managed by the team. Prior to that, she worked as part of the Fixed Income Platform Strategy and Communications team. She began her career at BlackRock working on the Institutional Sales team. Katie has nine years of investment experience. She holds a BA in Economics and Political Science, cum laude, from Tufts University.

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