How Mortgages Can Enhance Investment Returns

At $7.9 trillion in market value, residential and commercial mortgage-backed securities (MBS) comprise over 20% of the US fixed-income universe. By adding significant yield and diversification against other asset classes, residential and commercial MBS play an important role in investors’ overall bond portfolios.

We view the current macroeconomic environment as favorable for MBS. Our outlook is that the US economy will grow at a modest pace, in the area of 1.5%, with consumer spending remaining buoyant while business investment remains sluggish. As a result, the Federal Reserve will maintain a cautious approach to rate normalization, and Treasury yields will remain low and range-bound. Against this backdrop, we see long-term fundamental value in the following areas:

• Residential Mortgages. Residential mortgages are supported by low primary rates, conservative underwriting and muted homebuilder activity. We are constructive on agency mortgages as a high-quality, liquid alternative to sovereigns as they provide a substantial pickup in yield for both domestic and foreign investors, even net of currency hedging. In the non-agency sector, we are particularly positive on credit risk transfer deals,¹ as they trade at attractive spreads compared to other credit alternatives.
• Commercial Mortgages. The commercial real estate market has benefited from strong capital flows from foreign investors in search of higher-yielding real assets. We expect property values in core metropolitan business districts to remain stable and believe that loss-adjusted yields for commercial MBS, especially in the below-investment-grade sector, are compelling.

In today’s low-rate environment, residential and commercial MBS not only offer substantial yields (Exhibit 1) but also provide diversification against other asset classes. Agency and non-agency residential and commercial mortgage spreads have historically exhibited lower correlation with equity market returns as well as other fixed-income spread products (Exhibit 2), a trend that we believe will persist. If economic growth disappoints going forward, MBS may be less adversely affected than other risk assets, as lower mortgage yields should mitigate the risks of rising delinquencies. Conversely, acceleration in the pace of the economic recovery should further improve debt service ratios and result in tighter spreads.

We believe investors should consider an allocation to residential and commercial mortgages in their portfolios. With over 4 decades of experience in the sector, Western Asset utilizes an active approach towards managing MBS mandates. We believe that rigorous analysis of loan-level characteristics and deal structures are key to maximizing investment returns in the MBS sector, and that an active management approach can add meaningful value to an MBS allocation.