Seizing the opportunity in US agency MBS

Since late 2022, US agency mortgage-backed securities (MBS) have emerged as an attractive investment opportunity due to historically wide spreads relative to Treasuries. This valuation anomaly was primarily driven by the Federal Reserve's quantitative tightening and a regional banking crisis, which caused major market participants to exit, leading to higher spreads demanded by money managers. Despite these challenges, the fundamentals of MBS remain strong, with low negative convexity and supportive US housing market dynamics characterized by low prepayment speeds and limited organic supply.

A phased investment strategy was implemented to capitalize on spread widening, with strategic allocations in production coupon MBS, which offered favorable risk-reward profiles. The outlook for MBS in 2025 remains positive, bolstered by moderating interest rate volatility, strong demand from money managers, banks, and foreign investors, and favorable supply dynamics due to slow housing activities. MBS continue to offer valuation anomalies, appearing cheaper across spread products and relative to investment-grade corporates, prompting increased allocations from money managers.

Key risks include potential sharp interest rate increases, increased MBS supply, and prolonged weak bank demand, though these are considered manageable. Additionally, the risk of government-sponsored enterprises exiting conservatorship is low but noteworthy. Overall, US agency MBS present a compelling opportunity for inclusion in diversified global bond portfolios, with strong fundamentals and market dynamics supporting their investment thesis as we approach 2025.