Seeking Alpha

Buy Mortgage-Backed Securities For A Dropping Interest Rate Environment

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Includes: MBB, TLT
by: Thomas Evon
Thomas Evon
Long/short equity, value, contrarian, long-term horizon
Summary

The Fed will most likely lower rates in the coming 36 months.

MBS offer an alternative way to invest in lowest-risk fixed income.

Demand for MBS may increase if corporate debts get downgraded.

Saying the words “Mortgage-Backed Security” still makes the common investor shiver, and for good reason. The commonly misunderstood Mortgage-Backed Security (MBS) is a frequently cited cause of the 2008 financial crisis. Now, as it seems the world is growing more wary of signs of a new approaching recession (inverted yield curves, slowing manufacturing data, trade wars, global weakness, etc.), saying the words “mortgage-backed security” seems like a huge no-no. However, it seems that this forbidden security may be a great play in the current environment of uncertainty.

The financial markets are in a funky place. The Fed is now offering $100 billion a day in emergency repo loans to 24 primary dealers as of the past couple weeks. The Federal Funds Rate spiked up to around 9% during this period. When the Federal Reserve targets this rate to sit at an upward bound of 2%, it is sure that something is off. To make things more interesting, it seems that these issues are not blips. The Fed has indicated that it is considering the development of a permanent emergency facility to balance out the reserve markets.

What does this all mean? First, an observation of the reserve system is in order. The Fed amassed massive amounts of assets post the 2008 crisis in an effort to keep this rate low, but has since stopped its buying, hoping to “unwind” its balance sheet. As such, there has been a massive decrease in private (non-Fed) supply in the reserve market during the past few years. A quick look at this graph tells the story:

(Source: Excess Reserves of Depository Institutions)

The financial system has been spoiled again. The system has grown reliant on the low interest rates of the past decade. Now that the Fed has stopped pumping supply of the Fed Funds market, in other words, stopped consistently buying up debt assets, the market is again starving for what seems like an abundant supply of reserves.

This abundant supply of reserves has only fed a few hungry banks. Only the largest banks have been able to hoard the reserves dumped out of the Fed. These reserves, the staggering $1.3 billion of them, are concentrated among a few big New York banks. As for the rest of the country, the regional banks are still starved for cash. This puts the Fed in an interesting “pushing on a string” scenario. It seems that the more it stimulates, showering the banking sector with cash, the less effect it has (hence the perceived need for a permanent $100 billion a day in emergency funds). On the other hand, the Fed must not raise rates, risking the reserve-poor regional bank’s solvency and further liquidity crunches in the Fed Funds market. Facing a tame inflation rate, it becomes more likely that the Fed will not raise rates anytime soon. Combined with impeachment uncertainty, ongoing trade issues, stagnating personal consumption and incomes, wild commodity swings, a 2008-level manufacturing index, a lagging services sector, and European tariff wars, there are a plethora of incentives for the Fed to maintain or decrease interest rates in the coming 1-3 years.

Corporate debt spreads are already tight (historically):

(Source: Risk Spreads are Already Tight)

Trying to profit off of a lowering rate environment by investing into high-duration, broad baskets of investment-grade debt does not seem like a prudent choice. With the yields already pushed down, the risk compensation is not robust. Additionally, institutional investors of investment grade debt have mandates that will quickly force them to sell out of these holdings if they fall into junk. Currently, the majority of investment-grade bonds are BBB, and some 20% of these BBB bonds are BBB-, just one rating above junk. Clearly, the risk of any economic hardship driving an increasing percentage of these BBB rated bonds into downgrade is something that cannot be ignored.

(Source: Corporate Debt is Heavily Concentrated in BBB)

If you support the decreasing interest rate thesis, and if you believe a recession is approaching for the short-to-medium term, the most undervalued short-to-medium term duration, risk-free assets, offer the greatest opportunity to capture the greatest price appreciation. Because of all of the uncertainty, having an income component is advantageous as well.

Mortgage-backed securities offer a chance for price appreciation, risk-free characteristics, and a short duration, making them a candidate for seeking a fixed-income play on a falling rate environment. Price appreciation of MBS can come from a few sources. Primarily, expected gains come from a “flight to safety” mentality of investors during a crisis and credit crunch. As uncertainty rises, appetite for risk falls and investors typically pour into sovereign debt and reserve currencies.

Although the obvious choice to profit off of a “flight to safety” mentality may be US treasuries, I believe more value could be derived from allocating a portion of a portfolio towards MBS. If any economic environment creates heightened uncertainty, investors will pour into whatever safety they can find. With MBS ETFs currently yielding around +100bps compared to Treasuries, the asset class is a clear choice for funds that are starved for yield (consider institutions facing negative interest rates in Europe). Additionally, with the yield curve on US Treasuries already flattening or inverting, it is clear that the fear has already become “priced in”. With the Fed unwinding its holdings of MBS securities by a sum of $50 billion a month, there has been a lack of Fed buying pressure in the MBS market, presenting a great opportunity to get in. As of September, this unwinding has stopped, however, so the time to get in is sooner rather than later.

Next, MBS are safer than you think. (Yes, I know what that sounds like.) The top tranche of MBS is most protected from prepayment and default risk, as the more junior tranches must bear these losses first. Thus, top-tranche MBS securities earn AA and AAA ratings from their wide diversification, layering of protection from default, and underlying guarantees of mortgages from the US government. While the lower tranches have a strong negative convexity (as interest rates go down, prepayment risk goes up and the lower tranches take a hit), the highest tranches experience more normal, short duration (more about this later).

Thus, within the MBS universe, I propose investment into the iShares MBS ETF (MBB) in order to gain indirect exposure to the MBS market. MBB invests 100% into AAA rated mortgage-backed securities, 93.48% of which come from Freddie Mac, Ginnie Mae, and Fannie Mae. That means the fund is almost entirely made up of 30-year, fixed-rate mortgages bought from lenders to low- and moderate-income borrowers. Of this pool, the maturity breakdown is as follows:

(Source: MBB makeup)

MBB holds primarily maturities within the 3-7 year range with a weighted average maturity of 4.68 years.

The ETF is stable, with a beta of -0.04 calculated against the S&P 500 index, a standard deviation of 2.52% (3-year), and over the past 10 years, it has experienced a maximum drawdown (from peak to trough price) of only -3.23%. Most surprisingly, when the S&P 500 index lost around -38% in 2008, MBB gained around +3% that same year.

MBS ETFs infamously have a negative convexity, meaning that they act opposite to traditional fixed-income assets. In other words, in a falling rate environment, price is expected to depreciate. MBB has a convexity of -1.62; however, this convexity is offset by an effective duration of 2.04 years. When plugging these values into the full-price sensitivity equation, MBB offers a safe chance for price appreciation without much risk in the lesser-likely rising rate environment:

(Source: Author)

On either side of a 25bps cut/hike, MBB can expect to appreciate/depreciate by 51bps. For either side of a 50bps cut/hike, it is expected to appreciate/depreciate by 102bps, respectively.

Compared to longer-duration options, like the iShares 20+ Year Treasury Bond ETF (TLT) that invests in 20+ year Treasury Bonds (with a duration of 18.11, and a convexity of 4.14), you can expect to see much less volatility/risk in this holding. See below for the chart of the TLT present value estimations:

(Source: Author, data from iShares)

If the YTM increases/decreases by 25bps, TLT is expected to appreciate/depreciate by 453bps, 8 times the magnitude of MBB. Based on present value calculations, long-duration bond ETFs like TLT will experience the greatest price gains in a dropping interest rate environment. However, this opportunity comes at the sake of a lot more risk, with a yield that is ~ 100bps lower than that of MBB.

Thus, in place of defensive stocks, or for diversification to a fixed-income portfolio, MBS could offer a unique play on anticipated uncertainty and risk aversion. With its low risk, MBB sheds off a weighted average coupon of 3.70%. More, the net expense ratio is tiny, at 7 basis points, offering a cheap and easy way to gain income through MBS exposure.

The MBB play is neutral. It does not bet on interest rate movements as much as it bets on a flight to safety attitude in the coming 1-3 years, as well as great compensation (~10-year Treasury + 100bps) in the meantime.

As a complement to other fixed-income holdings, MBS stand to offer attractive safety income for the years ahead.

Disclosure: I am/we are long MBB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.