The Federal Reserve (Fed) indicated earlier this month that its balance sheet reduction would start this year. One fixed income sector likely to be particularly affected by this normalization process: mortgage-backed securities (MBS).
Housing was at the core of the financial crisis. To curb this crisis, the Fed bought some $ 1.8 trillion in mortgages. MBS yield spreads to Treasuries—a proxy for home borrowing costs—have slumped back to pre-crisis levels, in line with the expansion in the Fed’s holdings, as the Good for homeowners chart below shows.
We believe this has diminished their traditional attractiveness as an alternative to Treasuries that provides similar default-free risks but with higher income.
A normalization of the Fed balance sheet would likely involve eliminating most of the central bank’s MBS holdings over time. MBS valuations today reflect anticipation that this process will go smoothly—as well as benign expectations that rates will rise only gradually. These expectations are not limited to MBS—credit spreads as well stand at or close to post-crisis tight levels. This leaves little margin for error, we believe, and is reflected in our neutral stance on MBS and preference for higher-quality credit in today’s environment.
However, this is the first time the Fed has ever used asset reductions as a tightening (or normalizing) tool, making the actual impacts uncertain. As such, the Fed is likely to proceed cautiously with its unwinding. Read more in my full fixed income strategy piece Crossing the river by feeling the stones.
Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today’s environment.
Investing involves risks including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners. 189991