Mortgage bonds are close to the cheapest they’ve been since the financial crisis by some measures, and money managers like Pacific Investment Management Co. are betting that prices have fallen far enough to make the securities a great buy now.
Investors including DoubleLine Capital, Vanguard Group and Morgan Stanley Investment Management are also piling into the debt from US-backed entities like Fannie Mae and Freddie Mac. TCW Group views the bonds as one of the firm’s highest-conviction investments now.
They’re drawn by an unusual shift in the bonds. Mortgage backed securities usually get hit particularly hard by unexpected changes in interest rates, which change how often consumers refinance their home loans and how quickly investors get their principal returned to them. That sensitivity is known as negative convexity, but it’s all but disappeared for now, because home loan rates have surged and most homeowners are far from being able to refinance and prepay their loans.
“Homeowners are unlikely to refinance their mortgages given the unprecedented rise in interest rates in a short period of time,” Dan Hyman, manager of the $6.4 billion Pimco Mortgage Opportunities and Bond Fund, said in an email. “That means prepayment risk – something unique to the securitized market and a reason why these bonds typically yield more than U.S. Treasuries – is highly predictable.”
That kind of predictability may be why mortgage bonds jumped 2.5% on Nov. 10, their biggest one-day gain since June 1988, after a government report showed inflation cooling, and have risen about 5% since late October according to Bloomberg index data.
Even with these gains, risk premiums on the bonds are close to their widest level in a decade, excluding the early part of the pandemic. The gap between the 30-year Fannie Mae current coupon yield and a blend of five- and 10-year Treasuries was about 1.4 percentage point on Monday, and was as wide as nearly 1.8 percentage point in mid-October. That’s also part of why money managers have been buying.
Laird Landmann, co-director of fixed income at TCW, said now is the best buying opportunity since the global financial crisis, when the bursting of the mortgage bubble resulted in outsized returns for investors willing to be contrarians.
MBS made up 45% of TCW’s Metropolitan West Total Return Bond Fund’s $64 billion portfolio -- its biggest holding -- as of Sept. 30. That’s up from 36% at the end of last year.
“It’s setting up to be very attractive,” Landmann said in an interview at TCW’s Los Angeles headquarters. “Seasoned residential real estate debt is like gold.”
To be sure, mortgage bonds face potential difficulty in upcoming months. The Federal Reserve used to be the biggest buyer of the securities, but this year it has effectively stopped purchasing. It holds $2.67 trillion of the bonds in its portfolio, out of a market that is about $8 trillion.
With the biggest buyer effectively out of the market, it’s not clear who will step in now, Bloomberg Intelligence analyst Erica Adelberg said. That can weigh on prices for the securities. And at some point, the Fed may look to sell down its holdings, which would weigh on the bonds even more.
“Mortgages have been hit on all fronts,” said Brian Quigley, senior portfolio manager at Vanguard, in a phone interview. “The Fed has stepped back, there’s a historic rise in rates that we haven’t seen for decades and a post-’08 record spike in volatility.”