Following the Global Financial Crisis (GFC), valuations for the almost $9 trillion agency mortgage-backed securities (MBS) market have been subject to the demand of two major buyers — the Federal Reserve (Fed) and U.S. banks — who, combined, currently hold approximately two-thirds of the market. The Fed purchased MBS through four rounds of quantitative easing, with the most recent starting in March 2020, in response to the economic disruptions brought on by the COVID-19 pandemic. Banks traditionally invest a portion of their deposits in MBS to earn net interest margin (NIM), the spread between what they earn from holding MBS and what they pay on deposits. Bank demand for MBS increased in 2020 in response to elevated customer deposits and the Fed holding rates at zero.
In 2022, the Fed ended quantitative easing in March and started reducing the size of its MBS holdings in June through passive runoff. The Fed also began raising its policy rate to combat inflation, increasing it from the target range of 0.00-0.25% in March 2022 to 5.25-5.50% in July 2023. As interest rates rose and the yield curve inverted, bank demand for MBS declined. Yield curve inversion — when short-term interest rates are higher than longer-term rates — reduces net interest margin due to the short-term nature of bank liabilities (deposits) relative to the longer-term nature of its assets, such as MBS.
Today’s Chart of the Week shows valuations for MBS as measured by Bloomberg’s MBS Index. With the two dominant buyers pulling back from the market, money managers are stepping in to buy MBS at more attractive valuations. For money managers, the relative value proposition of MBS compared to other high-quality asset classes has improved substantially. Investors are being compensated more than before for taking on the convexity risk1 embedded in MBS. Although the par ($100) priced current coupon mortgage is approximately 6.00%, the majority of outstanding MBS carries a lower coupon and trades at substantially discounted dollar prices, which mitigates convexity risk.
2023 marks the first year since the GFC where banks and the Fed have both reduced their MBS holdings. Money manager demand for MBS should continue driving valuations for MBS relative to other sectors as we enter 2024. While the Fed is expected to continue passive balance sheet runoff of its MBS holdings next year, the Fed’s next move regarding interest rates will influence whether or not bank demand for MBS picks back up.
1Convexity risk in MBS comes from the option given to mortgagors to pay off their mortgage early. When interest rates fall, mortgages are generally paid off at a faster pace and refinanced at lower rates, which decreases the duration of MBS. The opposite generally occurs when interest rates rise.
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