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Midyear review and outlook: Why agency MBS may be more attractive than investment grade corporates

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      By Alexander Payne, CFAPortfolio Manager, Global Income Group, Eaton Vance Management

      Boston - At the midway point of 2019, it's helpful to review where we've been and look forward to where we're going. Stocks have soared to all-time highs, rates hit multi-year lows and credit spreads continued to grind tighter. It's been a great start to the year for most assets!

      Now for the hard part: finding value in the second half of the year when everything seems to be priced to perfection. Focusing on what is oftentimes the largest portion of investors' fixed income portfolios, getting the allocation right in your "conservative" bucket between government agency guaranteed mortgage backed securities (MBS) and investment grade corporate bonds can produce meaningful outperformance versus the Aggregate Bond Index. So which one offers the most value today?

      Spreads

      Agency MBS spreads are now wider than single-A corporate bonds for the first time since 2014. The sector widened 38bps over the past year to +94bps and is 23bps wider than average versus 9bps tighter than average for Single-A corporates. The move in agency MBS was largely caused by an increase in prepayments after mortgage rates fell, resulting in a higher supply of new MBS to the market. Now that the busy summer months for residential real estate are coming to an end, we expect the market to absorb this supply and spreads to revert back to historical levels. Edge: Agency MBS.

      MBSchart1

      Credit

      A-rated corporate bonds have a 5 year cumulative default rate of 0.7% since 1970 versus 0.0% all-time for AAA-rated US government debt. Edge: Agency MBS.

      Beta

      This measures an asset's sensitivity to stock market swings. For some bonds in your portfolio you want a high beta that in good times can produce a higher return, but for the part of your portfolio that holds US government bonds and high grade corporates the goal is to act as a stabilizer and not move with equities. Over the past 5 years the excess returns from Agency MBS are minimally correlated with S&P 500 monthly returns, exhibiting just a 0.03 beta. Corporate bonds, on the other hand, have a much higher correlation to stocks with a beta 6x higher at 0.17. Edge: Agency MBS.

      MBSchart2

      Liquidity

      The most underappreciated risk in financial markets today is liquidity. In some markets you are compensated for this risk (i.e. private equity), but for investment grade bonds you are not. Everyday $270 billion worth of agency MBS is traded, making it the second most liquid bond market in the world behind only US Treasurys. Fewer than 1/6th as many corporate bonds are traded each day. Edge: Agency MBS.

      MBSchart3

      Bottom line: Agency MBS offers more attractive spreads, better credit, less beta and deeper liquidity than investment-grade corporates.

      The ICE BofAML US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate and hybrid residential mortgage pass-through securities publicly issued by US agencies in the US domestic market.

      ICE BofAML Single-A US Corporate Index is a subset of ICE BofAML US Corporate Index including all securities rated A1 through A3.

      Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index measures agency mortgage-backed pass-through securities issued by GNMA, FNMA, and FHLMC.

      Bloomberg Barclays U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.

      Standard & Poor's 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.