Portfolio manager explains why one major competitor for assets is not deploying capital right now
In the heady stimulus-rich, free-capital days of 2020 and 2021 US banks bought a lot of long-duration bonds. In part mandated by liquidity requirements in Dodd-Frank, in part due to the glut of cash floating in the US economy, these major players invested heavily in fixed income securities. When interest rates started rising in late 2021 and through 2022, the bond allocations these banks held fell underwater.
That drop was one key factor in the small financial crisis that we saw in Spring of last year, when two smaller regional US banks collapsed. It remains a key factor in the current behaviour of US banks. Alfred Murata explains that the loss position many of these banks are still left in with their long-duration bonds has opened up an opportunity for other investors. Murata is a portfolio manager in mortgage credit with PIMCO. He notes that because these banks are in a loss position, they are more reticent to sell any of their securities, which means that banks aren’t moving to capture opportunities now left open to other investors.
“We're seeing that the banks are trying to raise more liquidity. One way to raise liquidity is to sell assets, but because many of those securities are underwater, that's going to result in realized loss. So, there are actually not many sales of assets that are taking place,” Murata says. “There are investments that the banks typically would have liked to have such as investing in agency or government mortgage-backed securities, or other high quality asset backed securities or loans, but banks are not deploying capital to acquire them.”
Murata highlights this opportunity in the context of a fixed income market that offers attractively high yields and the prospect of capital gains when central bank interest rates do come. He sees the lack of bank competition in mortgage-backed securities as a useful area where investors may be able to differentiate themselves. His team at PIMCO is paying attention to agency mortgage-backed securities in particular. These bonds, he explains, have a guarantee from the US government itself, or a government agency. That guarantee means credit quality is typically very strong — around a triple-A rating — at the very least stronger than most investment grade corporate bonds. They also come with a lower spread relative to treasuries than typical investment grade corporates.
Murata notes that not only have major US banks stopped buying these mortgage-backed securities, but the US Federal Reserve has stopped buying them as well. That’s due to the Fed’s quantitative tightening policy. The Fed already owns more than $2 trillion USD in mortgage-backed securities, but the lack of new purchases have contributed to those wider spreads for mortgage-backed securities compared to investment grade credit.
“Today, you're getting about 140 basis points of nominal spread in agency mortgage-backed securities and in investment grade credit, you might only get zero 90 basis points,” Murata says, “Typically you get more spread in the investment grade credit space than the agency mortgages.”
While he says that this opportunity is now open for both retail and institutional investors, Murata notes that there are some complications that could arise due to a lack of broad understanding among Canadian investors. Investment grade credit is an area that many investors are already well aware of, but despite the roughly $8 trillion dollars of agency mortgage-backed securities out there on the market, Murata says that many don’t full grasp it.
The current opportunity in mortgage-backed securities is something of a closing window, according to Murata. The unrealized losses that keep banks from participating in this market right now may become less of a factor when we see central banks cut interest rates. The value of those securities should rise when that happens, and banks may be more willing to liquidate them to move into mortgage-backed securities. As the yield curve reverts to an incremental pickup in yield over the longer-term, Murata also believes that the long-term yield advantage of these mortgage-backed securities should expand, bringing banks and institutions back into the asset class.
“If short-term rates go down, then what we’ll see is the yield advantage of these agency mortgage-backed securities is going to expand compared to investing in treasuries,” Murata says. “That will likely be the time that banks look to deploy more capital into these assets.”
