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Neuberger Berman finds quality in agency mortgage-backed securities

Amidst a tough environment for fixed income, agency mortgage-backed securities are one of Neuberger Berman’s highest conviction areas of relative value in the asset class.

2022 was a tumultuous period for bond investors, and few seemed to know that their fixed income portfolios could perform so poorly when there’s a massive recalibration of interest rates higher. An inverted yield-curve environment has now persisted for nearly a year – and because they’ve only occurred a handful of times in the past, Neuberger Berman has looked back at past examples to figure out how to respond to it.

“What we’ve been doing in our portfolios is following the lessons of history,” Neuberger Berman managing director and senior portfolio manager Adam Grotzinger told the Inside Network’s Income and Defensive Symposium. “On one side we’ve been extending duration and on the other we’ve been going up in quality, and the quality we’ve been taking has been via the agency mortgage-backed market… This is one of our higher conviction areas of relative value in fixed income.”

These are pools of mortgages in the US that are sold to Fannie Mae and Freddie Mac –  government sponsored entities – where they guarantee the timely payment of principal and interest to investors in these pools. The mortgages are “conforming and conventional” – they have verified income for the last two years, a debt-to-income ratio of less than 45 per cent, their FICO credit score is not subprime and it’s not a “jumbo loan”. And with what happened with interest rates in 2022, the market is now presenting value. Neuberger Berman likes two parts of the market – the first is the outstanding pools of mortgages.

“The speed of monetary policy adjustment from 2022 effectively has these low- to mid coupon mortgages trading at roughly 85 cents on the dollar,” Grotzinger said. “That’s an interesting market opportunity because some home owners still have to refinance or move house or change mortgages, and that will create a pass through of the principal back to investors in these pools.”

The other opportunity is owning current production mortgages, particularly the “5-6 per cent rate” mortgages issued in the last year or so.

“Not only is it AA, highly liquid asset with no credit risk, you’re getting a coupon of 5-6 per cent,” Grotzinger said. “But you’re also buying them at a high spread. “(The option-adjusted spread) is high versus long-term averages for a very simple reason: interest rate volatility is high… It’s a great income story, with the potential for some strong total returns as spreads normalise and interest rate volatility lessens.”

While this year has seen a headwind to supply, Neuberger Berman expects it to improve going forward. The headwind has been exacerbated by “everything you’ve read in the news” – the collapse of Silicon Valley Bank and other regional banks that had big mortgage portfolios that were a mismatch to their asset liabilities. Those mortgages have been sold by administrators into the market.

“We’ve been participating in some of those sales but it’s been a lot of volume that’s had to clear the market and created a bit of a headwind on supply in the short-term,” Grotzinger said. “But we think going forward the supply and demand picture is going to be better balanced.”

Staff Writer

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