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Benefits and Pensions MonitorAll AAAs Are Not Created Equal However, at some point, a bottom in the housing market and/or a further drop in subprime ABS prices will present bargain-hunting investors with attractive risk-adjusted opportunities. That is a subject for a future article. Prepayment Risk MBS typically enjoy a significant yield advantage over similar quality bonds issued by governments and corporations. What gives rise to that additional compensation is prepayment risk. While most Canadian MBS have limited prepayment risk (the Canadian banks price ‘open’ or prepayable mortgages prohibitively), most mortgages in the U.S. are prepayable without penalty, which represents a risk to the MBS investor. When interest rates go down, prepayments rise and MBS typically appreciate less than other bonds. When rates go up, prepayments fall below what was assumed and MBS depreciate more than other bonds. In effect, the homeowner with a prepayable mortgage is long a put option, while the MBS investor is short a put option. This perverse feature is referred to as negative convexity. The combination of high credit quality, yield, liquidity, and alpha potential make MBS an attractive investment. Yield, or income, is half or more of the battle in fixed income investing – getting well paid relative to the risks you are assuming. Over the last decade, U.S. Agency MBS have paid investors a nominal spread over U.S. government bonds of 90 to 270 basis points. Historically, MBS yields have overcompensated investors for the prepayment option. Many theories are offered to explain this, with the most fundamental being that the buyers of the prepayment option – millions of homeowners – are not price sensitive. Not only do they not explicitly see what they are paying for the option (since it is bundled into their borrowing rate), but they also lack the sophisticated option pricing tools necessary to properly value it. Modeling and valuing the prepayment option in MBS is more complicated than other options such as equity or government bond options, because the exercise (prepayment) isn’t solely dependent on the strike price. There is a complex set of factors that affect when a mortgage will be prepaid including yield curve shape, economic conditions, housing prices, death, divorce rates, innovation or competition within the mortgage origination sector, geographic location, how long the loans have been outstanding, housing turnover, household income, LTVs, and many other factors. Understanding and modeling prepayment risk has created full employment on Wall Street for many years! Liquidity The $4 trillion U.S. agency pass-through market is extraordinarily liquid. The Bond Market Association estimates that $300 billion trade every day and investors can often execute billion dollar trades at close to zero bid/ask spread. With large global investors, including central banks, increasing their allocations to this sector, we expect it will remain one of the most liquid financial markets in the world. PIMCO believes that the MBS market is one of the global bond market’s most attractive places to seek alpha. The sector experiences frequent mispricing, yet demonstrates very reliable reversion to fair value. Because MBS liquidity is so deep, it enables investors to monetize temporary mispricing. If the market is so liquid, why is there frequent mispricing? Trading in the MBS market is dominated by huge players whose trades are often motivated by factors other than maximizing total return, such as accounting or regulatory considerations. U.S. and global banks, mortgage originators, mortgage servicers, global central banks, and insurance companies are among the biggest investors in the sector and typically hold MBS for their high credit quality and/or outstanding risk-based capital treatment. However, accounting for MBS and MBS derivatives has become increasingly complicated and costly for many of these players. A parade of new accounting regulations by FASB and the IASB in the last few years have led to huge and chunky trading activity. When these large flows cause MBS to become cheap on an absolute basis, or relative to swaps and other bond market sectors, it presents opportunities for large investors. There are also frequent relative value opportunities within the MBS sector itself between different coupons and/or sectors, including 30-year versus 15-year pass throughs, seasoned pools versus TBAs (about to be issued MBS), fixed rates versus adjustable rates (ARMs), Agency versus Non-Agency, CMOs, IOs, POs, etc. Canadian Portfolios MBS are particularly attractive for Canadian portfolios. In constructing these portfolios, we scour the global bond market for investments that will help us improve overall risk-adjusted performance. U.S. Agency MBS help us accomplish that objective by offering the highest credit quality, generous yields, deep liquidity, and considerable alpha potential. Canadians lack a domestic sector with similar attributes. When U.S. MBS are held in Canadian core plus portfolios, swaps, futures, and forwards can be used to hedge interest rate and currency risk back to Canada. Since prepayment risk is not highly correlated with the main risk factors that determine the performance of the DEX (formerly Scotia Capital Universe) Index, namely Canadian duration, yield curve risk, or credit spreads, MBS increase the diversification in Canadian portfolios. To summarize, U.S. MBS can be used to benefit Canadian portfolios in three ways:
In our opinion, few sectors of the global bond market have the potential to add so much value to Canadian bond portfolios. ■
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Margaret Isberg is president of PIMCO Canada