Fed Buying Creates a $1.7 Trillion Agency Mortgage Market “Short Squeeze”

March 19, 2015

Fed Buying Creates a $1.7 Trillion Agency Mortgage Market “Short Squeeze” Photo

The Barclays U.S. Aggregate Index is the most widely-used benchmark for both actively and passively managed domestic fixed income strategies. This benchmark should logically be an accurate representation of the investable universe of securities within the U.S. investment-grade bond market.

However, since the Federal Reserve's decision to begin buying Agency Guaranteed Mortgage-Backed Securities (MBS) in November of 2008, Barclays has retained Agency MBS on the Fed's balance sheet as part of its Aggregate Index holdings. The decision to include MBS held by the Federal Reserve (and thus unavailable for purchase by investors) as part of the Aggregate Index is even more curious, considering Barclays has always removed the Fed's Treasury bond holdings from the Index.

The current Barclays approach to include uninvestable securities in the Aggregate Index has, in effect, created a short squeeze in the Agency MBS market. The result has been beneficial for mortgage borrowers but led to over-valuation for Agency MBS; PIMCO estimates a 14 basis point impact on the average mortgage interest rate from the Barclays methodology. While 14 basis points may seem like a small amount, in today's low interest rate world, every basis point matters for fixed income investors.

Key Takeaways: With the Federal Reserve now holding more than a third of all Agency MBS and a quarter of all outstanding Treasury issuance - with no plans to sell their holdings anytime soon - Barclays should eliminate its inconsistent methodology and remove the Fed's Agency MBS holdings from the Aggregate Index. The result would be an improved and more easily replicable benchmark for fixed income investors in addition to a more realistic valuation for Agency MBS.

Tags: Chart of the Week | Bonds | Federal Reserve | Barclays | Index | PIMCO | Mortgage-Backed Securities

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