Key takeaways:
- While tariffs and trade negotiations have unsettled equity markets, agency MBS have quietly recorded their best start to a year since 2020, with the Bloomberg U.S. MBS Index up 3.35% year to date.1
- In our view, agency MBS continue to look attractive due to their relative cheapness versus investment-grade corporate bonds, their history of acting as a ballast when equity markets sell off, and their unusually low prepayment risk right now.
- We believe investors should consider capitalizing on the unique opportunity to buy agency MBS to add defensive duration to portfolios and lock in higher yields.
Thus far in 2025, uncertainty has defined the narrative in financial markets amid the Trump administration’s tariff rollout and trade negotiations. While volatility has proliferated in equity markets, agency mortgage-backed securities (MBS) have quietly recorded their best start to a year since 2020, with the Bloomberg U.S. MBS Index up 3.35% year to date.2
We highlight three key reasons why we believe MBS continues to look attractive on both an absolute and relative basis.
1. Attractive valuations
Current coupon (CC) spreads on government-backed agency MBS have historically traded tighter than investment-grade (IG) corporates. Since 2022, however, agency MBS have paid a premium over IG corporates, as shown in Exhibit 1.
This phenomenon is largely due to recent strong demand-supply dynamics in the corporate sector, which have kept spread levels tight. Conversely, the MBS market has faced a more challenging supply backdrop due to quantitative tightening (QT), coupled with softer demand from banking institutions amid rising interest rates.
With QT drawing to a close and the Federal Reserve (Fed) well positioned for future rate cuts, we believe the anomalous spread differential is likely to unwind. In our view, the current valuation environment presents investors with an attractive relative value trade and a potentially lucrative entry point into MBS.
2. Defensive characteristics of agency MBS
Ongoing geopolitical tensions and disruptions to global trade are rattling equity investors, resulting in heightened volatility and an uptick in recession risk. Equity selloffs are not uncommon, and we recommend investors maintain a sufficient allocation to defensive assets to dampen equity market volatility.
As shown in Exhibit 2, agency MBS have historically acted as a ballast when equity markets have sold off, making it a suitable defensive diversifier, in our view. Agency MBS are backed by government-sponsored entities, which mitigates credit risk and adds high-quality duration to investment portfolios.
We believe their historical resilience during market selloffs positions agency MBS as a prudent choice for broad portfolio diversification and an insurance hedge given macroeconomic uncertainty.
3. Historically low prepayment risk
Prepayment risk is the primary fundamental risk for agency MBS, as homeowners may pay off or refinance their mortgage at any point. Refinancing typically increases when interest rates fall and homeowners switch to lower-rate mortgages.
Prepayments result in the duration of MBS falling when interest rates decline, a concept known as negative convexity. Negatively convex bonds such as agency MBS may not fully capture the price appreciation from declining interest rates compared to positively convex bonds, whose duration rises when rates fall. To compensate investors for this risk, MBS pay an additional spread above the yield on comparable U.S. Treasuries.
Due to an extremely low-rate environment in 2020 and 2021, over 70% of existing U.S. mortgages were originated at interest rates below 5%. With the current mortgage rate still well above 6%, there is no financial incentive for most borrowers to refinance. As a result, the agency MBS market finds itself in an unusual situation where prepayment risk and negative convexity are around all-time lows.
The low level of prepayment risk is also reflected in the average bond price, which has been around all-time low levels since April 2022, as shown in Exhibit 3. We believe investors should consider capitalizing on the unique opportunity to buy agency MBS at negligible levels of prepayment risk.
Summary
In our view, the attractive relative value proposition, extremely low prepayment risk presently, and historical resilience during market selloffs support a tactical overweight to agency MBS for investors seeking to add defensive duration to portfolios and lock in higher yields.
IMPORTANT INFORMATION
Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.
Definitions and Sources
1 Through 30 April 2025.
2 Through 30 April 2025.
Bloomberg U.S. Mortgage-Backed Securities (MBS) Index measures the performance of U.S. fixed-rate agency mortgage backed pass-through securities.
Convexity demonstrates how the duration of a bond changes as the interest rate changes.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Monetary Policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.
Quantitative tightening (QT) is a monetary policy where central banks reduce the amount of money in circulation by selling assets or allowing them to mature without reinvestment, effectively shrinking their balance sheet.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
Volatility measures risk using the dispersion of returns for a given investment.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
© Janus Henderson Investors
Read more commentaries by Janus Henderson Investors
