March Market Madness
Adam B Patota
In the quest for success, fixed income investors aim to win with bonds that deliver predictable cashflows and attractive returns. However, this pursuit has been challenging over the past year as many fixed income sectors have been disrupted by rising inflation, Fed policy tightening, and bond fund outflows.
In response to recent market turbulence and the potential for normalization, we’ve conducted extensive analysis on fixed income assets that demonstrate a strong correlation to indicators of market risk and volatility. This analysis enables us to better predict the likelihood of our risk-adjusted returns co-moving with different risk factors, and it informs our portfolio positioning in response to the volatility outlook.
One way to measure risk-adjusted performance is with a framework that isolates total return into two main factors: 1) Returns due to interest rate exposure and 2) “Excess Returns”, which are returns due to an embedded risk premium. Excess returns help investors measure their compensation for bearing additional risks, such as credit risk or prepayment risk (a type of convexity risk), over long periods.
The table above reveals that, over the past year, Agency MBS excess returns have shown the strongest correlations to a risk factor called implied interest rate volatility. Implied interest rate volatility is a measure of expected future volatility or uncertainty in interest rates, as implied by the prices of certain derivatives such as options and futures contracts. Figure 2 shows the implied one-standard deviation move of 10-year swap rates over the next year, as derived from option prices. As seen in the chart below, this measure more than doubled in 2022, reaching the highest level in over 10 years.
Figure 2: 1 year x 10 year Swaption Volatility
But why does interest rate volatility matter so much for Agency MBS performance? Agency MBS investors are “short” a call option to a borrower who can prepay their mortgage loan at any point, and higher volatility adds uncertainty to the borrowers’ future behavior. As mortgage rates moved sharply higher in 2022, it no longer made sense for most US homeowners with generationally low fixed-rate mortgages to refinance or move homes. For Agency MBS, this meant cashflows would be received later than originally expected, causing durations to extend, and thereby exacerbating negative performance.
To supplement our analysis, we also examine how mortgages performed on days where volatility moved by a large amount. Over the past year there have been 51 trading days where interest-rate volatility increased by 2 or more basis points. Agency MBS excess returns were negative on 46 of those days (90% of the time), with an average daily excess return of -20 basis points.
Relative to all other major fixed income sectors, we’ve seen Agency MBS consistently show the most negative correlation to volatility over various time periods. Since the beginning of 2023, we observed an even stronger negative correlation of Agency MBS to changes in interest-rate volatility of -0.74. Recent volatility helps explain why, year-to-date, MBS excess returns are negative despite other positive factors (i.e. the market pricing in Fed policy cuts by the end of the year).
This dynamic creates the opportunity for investors to use Agency MBS to express a view on the direction of volatility. Agency MBS spreads are currently trading in the 95th percentile of spread levels over the past 20 years, with a par priced 30-year Agency MBS trading +155 basis points versus the Treasury curve. A decline or normalization in interest rate volatility from elevated levels would likely provide a strong tailwind for the Agency MBS sector to deliver positive excess returns going forward.
In conclusion, the recent surge in bond market volatility highlights the importance of understanding the drivers of fixed-income excess returns. By staying vigilant and monitoring key drivers like interest rate volatility, Fed policy expectations, and how those variables often move together, investors can position themselves for success in today’s challenging fixed-income environment.