CONTRIBUTORS
Ion Dan
Portfolio Manager
Western Asset
United States
In May, we outlined why agency mortgage-backed securities (MBS) deserve a place in the broader portfolio construction of reserve managers alongside Treasuries, Agency MBS – Expanding the Reserve Management Toolkit. Five months on, the fundamental case for agency MBS value has only strengthened.
As of late September, agency MBS yields stood at 5.95%—within striking distance of the highest levels seen in 2006, going back over two decades in the history of the Bloomberg US MBS Index (Exhibit 1). At current levels, agency MBS yields exceed those of Aa-rated corporate bonds, offering investors more income potential from investing in bonds secured by US residential loans with an implicit or explicit US government guarantee, compared to holding unsecured corporate credit exposed to the business cycle. In addition, agency MBS represents the second-largest and most-transacted US fixed income market rivaled only by US Treasuries, which is a key consideration for allocators.
Exhibit 1: Agency MBS Yields Near 23-Year Highs, Now Exceeding Aa Corporates
Source: Bloomberg. As of 30 Sep 26. Month-end yields: 30 Sep 02- 30 Sep 26. Aa corporate and US Treasury indexes shown for comparable maturity context.
The second pillar of the case for “why now?” is rooted in structurally low prepayment risk. The effective mortgage rate of the outstanding conventional 30-year mortgage universe sits near 4.5%, as most US mortgage borrowers refinanced into 2.5-3% mortgage rates during Covid, when the Federal Reserve’s mortgage purchase program (QE4) lowered rates to all-time lows. With current mortgage rates around 7.5%, there is very little refinancing incentive for borrowers. As shown in Exhibit 2, the gap between the effective rate of outstanding borrowers and prevailing mortgage rates is now running at -2.91 percentage points, close to the historical low of -3.83pp reached in October 2023. In plain terms: The overwhelming majority of outstanding mortgage borrowers have no economic reason to refinance. Mortgage prepayments are low, MBS cash flows are more predictable, and income potential for agency MBS is more attractive.
Exhibit 2: Refinancing Incentive Near Record Lows Signals Muted Prepayment Risk
Source: Bloomberg, Mortgage Bankers Association (MBA). As of 30 Sep 26. Month-end yields: Jan 00 – Sep 26. Effective weighted average coupon (WAC) of outstanding conventional 30-year universe vs. prevailing 30-year mortgage rate.
Taken together, these two conditions—yield levels near multi-decade highs and prepayment risk near multi-decade lows—do not arrive in combination often, presenting reserve managers with a compelling current opportunity to assess portfolio construction in favor of agency MBS allocations from a position of long-term fundamental value. This is not a call to abandon Treasuries or to reach for uncompensated risk. It is a call to examine current portfolios in the context of the yield advantage and diversification benefits of agency MBS.