In today’s risk-off environment, high-quality, government-guaranteed, U.S. Agency mortgage-backed securities are making a strong case for investors looking to reduce credit risk in portfolios. Additionally, MBS spreads have historically outperformed investment grade credit leading into a recession—a scenario that is looking increasingly likely in the second half of 2023.

MBS option adjusted spread vs. investment grade corporate option adjusted spread
Recessions are shaded, 1990–present

Line graph showing MBS option adjusted spread vs. investment grade corporate option adjusted spread, from 1990-2022

Source: Bloomberg, National Bureau of Economic Research (“NBER”), Principal Fixed Income. Data as of January 9, 2023. Indices represented are Bloomberg U.S. MBS Fixed Rate Index and Bloomberg U.S. Aggregate Corporate Index.

Strains on the global economy are building, and the probability of a U.S. recession in 2023 continues to rise. With a likely period of contraction looming, a focus on credit quality and reducing credit risk in portfolios will be important for investors. High-quality U.S. Agency mortgage-backed securities (MBS) are one asset class that’s well positioned to be a spread product of choice heading into a recessionary market environment.

For starters, U.S. Agency MBS are guaranteed by the U.S. government. That government backing, combined with little-to-no refinancing risk (the average 30-year fixed rate borrower is currently financed around 3.5% versus current rates above 6%), makes the asset class attractive in a risk-off environment.

Furthermore, MBS spreads have historically outperformed investment grade credit leading into a recession (given the government sponsorship of credit risk). Heading into 2023, technicals have also been improving, with slowing house price appreciation and housing activity reducing organic net supply. In fact, asset managers, eager to migrate out of credit and risk assets, have already started to target MBS in their portfolios.

With sound fundamentals, improving technicals and attractive valuations—combined with the increasing likelihood of a recession in 2023—high-quality U.S. Agency MBS will likely be rewarded as the economy weakens.

Read the full quarterly outlook from Principal Fixed Income for more themes, opportunities, and investment implications across global fixed income markets.

Disclosure

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results and should not be relied upon to make an investment decision.

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