Late last year, I had written about mortgage-backed securities (MBS) and how they came under pressure in 2022 as interest rates rose and interest rate volatility increased. MBS extend when interest rates rise, meaning investors in MBS receive cash flows further out into the future than originally anticipated. The extension-risk inherent in MBS can exacerbate losses on MBS as interest rates increase. Many U.S. commercial banks purchased MBS in 2020/21 as a way to earn net interest margin on the substantial deposit inflows they were experiencing. At that time, banks were paying next to nothing on their deposits, and the cash flows generated by MBS were thought to be an appropriate match for these deposits.
But on March 10 this year, Silicon Valley Bank became the second-largest bank in U.S. history to fail at the time and has since become the third-largest due to the subsequent failure of First Republic Bank. Two days later, Signature Bank failed. The Federal Deposit Insurance Corporation (FDIC) stepped in to seize control of the banks’ combined $114 billion securities (primarily MBS) portfolio. When markets reopened on March 13, interest rates had plummeted and spreads on fixed-income assets had widened.
As today’s Chart of the Week depicts, the reaction in investment-grade (IG) corporate bonds was more severe than in MBS. However, over the next month, spreads on IG corporates recovered while MBS spreads remained under pressure as investors prepared for the FDIC’s sales of its newly acquired MBS portfolio. This trend reversed on April 18, the day the FDIC began selling its MBS portfolio, and the spread between IG corporates and MBS has tightened since.
Despite MBS having no inherent credit risk due to government guarantees, the FDIC is expected to get back roughly 86 cents on the dollar for its securities portfolio versus the 100 cents on the dollar that depositors receive. While that fact may be a bit shocking, what has been more interesting as a fixed-income investor is the relative strength of mortgages since the start of the FDIC’s sales. One good indicator of this strength is the FDIC’s sale of roughly $1 billion non-agency mortgages at levels 20 to 30 basis points tighter than just prior to the sales.
MBS reacted poorly to the FDIC’s seizures of Silicon Valley Bank and Signature Bank but have fared better since the FDIC began selling in mid-April. There are several factors that may help explain the relative strength in mortgages since then. First, MBS valuations cheapened during the fallout from March’s bank failures, and the FDIC’s sales may have presented investors — primarily money managers who have been underweight mortgages — with a scalable opportunity to increase their exposure to mortgages. Second, with the end of the Federal Reserve’s interest rate increases widely expected, interest rate volatility has fallen, which is a tailwind for MBS valuations. Lastly, investors’ concerns about a deteriorating economic outlook could drive inflows into this high-quality, government-guaranteed asset class.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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