Nominal Spreads on Mortgage-Backed Securities Remain Wide Relative to Investment-Grade Corporates
September 11, 2025
The nominal spread for an agency mortgage-backed security (MBS) is the difference between the MBS yield and a Treasury security with a comparable maturity. It measures the extra yield the MBS earns over benchmark Treasuries, typically a blend of 5- and 10-year Treasuries. The nominal spread does not account for prepayment risk in the MBS, which can increase or decrease the weighted-average life (WAL) of the MBS.
Prepayment risk is the risk that the mortgage borrower will repay the principal amount on their mortgage earlier or later than expected. Prepayments increase as interest rates fall, as existing borrowers can refinance into lower mortgage rates. By the same logic, prepayments decrease as interest rates rise. This is also called extension risk. Prepayment options for home borrowers leads to MBS prices being capped on the upside and more sensitive on the downside, increasing the risk for investors in volatile interest rate environments. For MBS, the option-adjusted spread (OAS) incorporates the option cost arising from prepayment risk when calculating the expected return for investors.
OAS for investment-grade (IG) corporates and MBS have retraced the widening that occurred in 2022 and 2023 during the Federal Reserve’s rate-hiking campaign to combat inflation. MBS OAS is currently in line with long-term averages, while IG corporate OAS is near all-time tights. Credit spreads in other sectors such as high-yield corporates, non-agency RMBS and asset-backed securities (ABS) are also trading near local tights. Meanwhile, MBS nominal spread remains wide, suggesting option costs embedded in MBS (which OAS captures) remain elevated.
Key Takeaway
Because many agency MBS are backed by government guarantees, investors are compensated for taking convexity risk rather than credit risk when investing in MBS. The wide nominal spread on MBS relative to OAS suggests convexity risks are high, indicating MBS prices will be especially sensitive to any interest rate changes. Finding effective strategies to mitigate convexity risk is a way to produce attractive returns in this environment.
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