Making the Move to Mortgage-Backed Securities

Key takeaways

• One of the biggest asset classes in the U.S. bond market is agency mortgage-backed securities (MBS), which can be a way for advisors to diversify clients’ portfolios with investment-grade credit.
• BlackRock's Multi-Asset Income model portfolios recently increased their weighting in MBS, highlighting the attractiveness of the asset class right now.
• We examine the case for MBS now and the role they can play in portfolios.

Making the Move to Mortgage-Backed Securities.

With yields higher across the bond market, investors don’t need to look far afield for income producing investments. One of the biggest asset classes in the U.S. bond market is agency mortgage-backed securities (MBS), which can be a way for advisors to diversify clients’ portfolios with investment-grade credit that has been trading at attractive levels. Agency MBS could also serve as a diversifier for investors seeking to reduce U.S. Treasury exposure.

BlackRock’s Multi-Asset Income model portfolios recently increased their weighting in MBS. Karen Veraa, Head of iShares U.S. Fixed Income Strategy and Justin Christofel, Portfolio Manager and Co-Head of Income Investing for Multi-Asset Strategies & Solutions at BlackRock, recently discussed why he made the move, and the role MBS can play in portfolios.

Karen: Why are Agency MBS attractive now?

Yields have increased on mortgage-backed securities as the Fed hiked rates. MBS offer investment grade credit quality and a yield-to-maturity of almost 5%, based on the Bloomberg MBS Index, as of 6/30/23. The prepayment risk of agency MBS has decreased as many homeowners refinanced mortgages in 2020-2021 at lower interest rates. In fact, about 78% of the index has coupon rates below 3.5%, which means these homeowners are less likely to prepay those mortgages given current mortgage rates are over 6.7%.¹

Under these conditions, we believe MBS bonds are likely to behave with more cash flow certainty. In this higher interest rate environment, homeowners with lower rates are less likely to refinance and prepay their mortgages. So, the estimates for prepayments are reduced and bonds remain outstanding longer with higher yields. With longer average lives, the average duration of Bloomberg MBS Index has extended to 6.1 years in June 2023 from a low of 1.3 years in March 2020.² The duration has also been more stable since interest rates increased.

Additionally, the yield premium of MBS over US Treasuries (i.e., the “MBS basis” is near a 10-year high (see the chart below). In the past year, the Fed has stopped quantitative easing and is slowly running off its MBS holdings, which have declined by $174 billion to $2.5 trillion.³ The Fed is holding about 37% of all agency MBS and this reduction over the past year amounts to about 2.5% of the total market value outstanding.⁴

With this large buyer not in the market, current investors are demanding a larger premium for holding MBS, so the mortgage basis has increased from a low of 62 basis points on May 28, 2021 to 163 basis points compared to similar duration US Treasury bond yields, as of June 30, 2023.⁵ Even compared to corporate credit, the additional yield premium on MBS looks relatively attractive.

Karen: What role do agency mortgages play in a portfolio?

Justin: If you hold a core fixed income ETF like the Bloomberg US Aggregate Bond Index (AGG), you already have exposure to agency MBS, which is about 27% of the AGG Index and 23% of the Bloomberg Universal Index.⁶ Given that the Bloomberg MBS Index currently has a duration of 6.0 years, investors can use it to add high quality duration back to portfolios. Using data from thousands of moderate portfolios analyzed by BlackRock’s Advisor Center, advisors are still underweight fixed income by about 7%, so adding mortgages could help get those portfolios closer to benchmark weights.⁷

Karen: You recently added agency mortgages to the Multi-Asset Income model portfolios, why did you increase the weight of mortgages and what did you sell to buy them?

Justin: First, from a portfolio construction standpoint, we like adding diversifying exposures particularly given the wide range of possible economic outcomes. Agency mortgages fit the bill quite well given their investment-grade rating and the fact that their economics are unrelated to corporate credit, where we already have a fair bit of exposure.

Second, as you touched on, mortgages trade with a spread over Treasuries reflecting pre-payment risk. When interest rate volatility increases, mortgages have tended to underperform and when it decreases, they’ve tended to outperform. Since the beginning of 2022, interest rate volatility increased significantly to the highest levels we’ve seen in a decade, peaking around regional bank crisis in March. Since then, we have started to see it normalize, but it’s still quite elevated by historical standards. With inflation moderating and the Fed likely approaching the end of the hiking cycle, we expect rate volatility to subside, making agency mortgages an attractive high-quality asset to own over the coming year. To increase the weight of MBS, we reduced our exposure to high yield bonds and preferred stocks.

Investors can access MBS through mortgage ETFs like the iShares MBS ETF (MBB) and the iShares GNMA Bond ETF (GNMA) or in core bond ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG) and theiShares Core Total USD Bond Market ETF (IUBS).

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