(Bloomberg) -- Money managers including Pacific Investment Management Co., fed up with ultra-expensive corporate bonds and wary of economic risks, are pouring money into mortgage debt. A fast-approaching Fed rate cut would only sweeten the deal.
Investors overseeing some $785 billion of assets are overweight agency mortgage bonds, holding more than their benchmark indexes would imply, according to an analysis from strategists at Citigroup Inc. The group holds about 12.9% more of the bonds than the Bloomberg Aggregate index, according to data through June, the biggest overweight position since the analysts started assessing the holdings in 2014.
Yield-sensitive buyers have been flocking to the securities because risk premiums are generous compared to corporate bonds and other credit markets, and yet they have essentially zero credit risk because they have what amounts to a government guarantee. The bet is that easier Federal Reserve policy will entice US banks back into a market they used to dominate and drive a surge in prices.
Pimco is piling in. The firm’s Pimco Income Fund, the world’s largest active bond fund with $153 billion in assets, is about 40% overweight agency MBS, a sharp reversal from its underweight of about 15% at the start of 2022. The bulk of its holdings are in bonds with higher coupons, which are poised to benefit the most from the decline in short-term yields that a Fed cut is likely to trigger.
“MBS are high quality in a world where there’s a decent amount of complacency about economic risks,” said Dan Ivascyn, the firm’s chief investment officer, said in an interview. “As long as we think that we’re not being compensated enough for the risks of other asset classes, we’ll hang out in agency MBS and wait for something to break before investing elsewhere.”
The move to overweight bonds backed by the likes of Freddie Mac and Fannie Mae, companies supported by the US government, began gaining steam around two years ago, just as the Federal Reserve and US banks retreated and left behind a void of demand. Even a year ago, fund managers were hailing MBS as a no-brainer investment that was “screaming cheap.”
And yet despite what looked like easy money, agency MBS have fallen short of corporate bonds, loans and other large liquid asset classes on a total return basis, according to Bloomberg data. That’s largely because both inflation and economic growth have proved resilient, leading the Fed to postpone interest rate cuts. Compared with a year ago spreads have narrowed but are still well above their average from the last decade.
It’s not the only mortgage play that’s getting investor attention. Insurance firms searching for yield are taking the unusual step of skipping mortgage-backed bonds and buying the underlying whole loans outright.
But for MBS, the trade is looking more like an idea whose time has come, with a Fed rate cut priced in for September.
“If the economy continues to cool down and banks return to the market, then MBS could tighten whereas corporates may widen,” said Yunkai Wang, a strategist at Citigroup. “Funds could benefit from their MBS overweight positions in that scenario and see better returns.”
The debt’s prospects depend in part on US commercial banks, which owned as much as 30% of the entire market when the Fed started tightening policy two years ago, according to Bloomberg Intelligence. But when rising rates spurred bank depositors to pile into higher-yielding money market funds, lenders had to reallocate to shorter-term investments from the longer maturities typical from MBS.
When the Federal Reserve cuts interest rates, prices of MBS and all other fixed income debt are set to rise. But for MBS, there’s an additional benefit: lower rates will likely cause bank deposits to climb, and restore their usual incentive to deploy deposits into long-term securities like MBS. Spreads are likely to compress as a result.
“When the Fed cuts interest rates a lot of cash will come in from off the sidelines,” said Scott Buchta, a strategist at Brean Capital, referring to bank assets. “Money managers don’t want to get left behind when that happens.”
Already, the prospect of a rate cut is uncorking new life for the asset class. MBS volatility is the lowest in two years, and banks are taking in more deposits and deploying some of it into the securities.
As an added bonus, its usual drawback — prepayment risk, or negative convexity in bond-speak — is minimal now. Vast swathes of homeowners are “locked in” to extremely cheap mortgages and thus unlikely to prepay their mortgages even if rates fall significantly.
“Agency MBS has been a bond value trap until very recently,” said Ken Shinoda, a portfolio manager at DoubleLine, whose $30 billion DoubleLine Total Return Bond Fund is 14.6% overweight the debt, according to Citigroup data. “That’s beginning to change.”
(Adds Elsewhere in Credit section after last paragraph)
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