Background on the agency MBS market

The agency mortgage-backed securities (agency MBS) market is the second largest U.S. bond market after Treasuries, constituting a broad investable universe with a substantial range of coupons. The rates of the underlying mortgages themselves are also quite diverse. The credit quality of agency MBS is a big part of their appeal. Ginnie Mae MBS are explicitly backed by the federal government, and Fannie Mae and Freddie Mac MBS are generally considered to be of very high credit quality.

We have shied away from this market for some time due to relative valuations. However, we are increasingly finding relative value opportunities among current coupon agency MBS.

Current market dynamics appear to favor agency MBS

Technical factors, both positive and negative, are at play for the mortgage market. The sharp rise in interest rates since the start of 2022 has depressed the supply of MBS pools by dampening demand for new mortgages. Similarly, prepayments across the entire mortgage market have slowed meaningfully as the highest rates in approximately 23 years have deterred refinancing. Unlike agency MBS, corporate bond yield spreads have meaningfully compressed versus U.S. Treasuries since March 2020. As the charts in Exhibit 1 demonstrate, while BBB-rated corporate bonds still yield more than agency MBS, the gap between the two has closed significantly in recent months, making agency MBS relatively more attractive on a risk-adjusted basis.

Exhibit 1: Corporate bond spreads vs. agency MBS spreads in perspective

Relative value opportunities are rising among agency MBS and falling among corporate bonds.

Sources: Schwab Asset Management; Bloomberg; data from 12/30/22 to 9/14/2023. Corporate bond spreads represented by U.S. corporate BBB-rated bond yields minus 10-year Treasury yields. Agency MBS spreads represented by the Morgan Stanley 30-year Conventional Current Coupon ($100) OAS Indicator.

Past performance is no guarantee of future results. Comparative indices are unmanaged, and it is not possible to invest directly in an index.

Our viewpoint on this relative value opportunity

From our perspective, agency MBS—particularly current coupon securities of 30-year residential mortgage pools trading just below par—look attractive given current market dynamics. Although we continue to believe that, broadly speaking, corporate bonds represent good value, select lower-rated corporate bonds are starting to look expensive relative to agency MBS. As a result, we have been selectively capitalizing on this opportunity to shift from corporate bonds to agency MBS. In the process, we have been adding quality, while potentially giving up very little yield.