Pimco Taps Battered Mortgage Bonds as Credit Gets Expensive

Investors looking for extra yield are driving corporate bonds to some of their tightest valuations of the year, pushing money managers including Pacific Investment Management Co. toward mortgage debt that looks much cheaper.

(Bloomberg) — Investors looking for extra yield are driving corporate bonds to some of their tightest valuations of the year, pushing money managers including Pacific Investment Management Co. toward mortgage debt that looks much cheaper.

New mortgage bonds now offer yields that are about 1.66 percentage point higher than US Treasuries, according to data compiled by Bloomberg. That’s the most relative to corporate bonds in 17 years. 

The Federal Reserve has hiked rates at the fastest pace in decades, and monetary tightening usually leads to more corporate defaults, said Noah Wise, a portfolio manager at Allspring Global Investments. Yet risk premiums in high-grade corporate bond markets have tightened as investors hunt for yield, hovering around 1.18 percentage point as of Wednesday. That’s tighter than the average for the last decade.  

Meanwhile mortgage bonds look appealing. Spreads on currently produced mortgage bonds have widened sharply for a variety of reasons, including liquidations of MBS once held by failed banks, and waning demand from banks and the Fed, which is letting MBS roll off its balance sheet. 

Add it all up, and mortgage bonds now offer an attractive spread over Treasuries and are a good option for investors to cut credit exposure, according to Mohit Mittal, a multisector portfolio manager at Pimco. 

“In the late stages of an expansionary cycle, you want to have less credit risk,” said Mittal. “One area where we find good value right now is in agency mortgages.” 

Those views were echoed by Pimco Chief Investment Officer Dan Ivascyn in June when he said in a Bloomberg Television interview that agency mortgages were the “most attractive asset” in public markets. Pimco manages almost $1.8 trillion in assets as of June 30.

Agency bonds are cheap to both their fair value estimates and investment-grade corporate bonds, Goldman Sachs Group Inc. strategists including Roger Ashworth wrote in a report dated Aug. 24. They reiterated their recommendation to be overweight, or to take an outsized position in agency MBS versus high-grade credit, saying they expect MBS spreads to tighten further into year-end.   

Not every investor is convinced that corporate bonds are overvalued relative to mortgages.

Greg Peters, co-chief investment officer at PGIM Fixed Income, is less bearish around the outlook for credit given the resilience of the US economy, but says buyers haven’t had to be as discerning as now in picking names and structures in the past decade. He has a positive view on agency mortgages over the longer term, though they look “a little fully valued” now, he said in an interview. 

“Agency mortgages look pretty reasonable versus IG credit at this point in time,” according to Peters. The guaranteed residential-securities sector “finally is a market that is worth evaluating” again after the Fed switched from quantitative easing to tightening, he said.        

But many investors are looking closely at the relative value in mortgage bonds as well. Allspring is betting that a recession in the US has been delayed but not avoided, which is partly why it’s more cautious on corporate debt, Wise said in an interview. In benchmark-oriented strategies, Allspring is underweight credit and overweight agency mortgages, he said. 

The credit world isn’t cheap and the spread you get for default and liquidity risk “is a little bit sparse,” Wise said. By contrast, the US agency-mortgage bond sector “is an area where you are getting some of the most attractive compensation for that exposure in the last couple of decades,” he said. 

MBS investors are bearing the risk of rates moving sharply and unexpectedly, Wise said. Eighteen months ago, investors weren’t getting compensated for that risk, but a lot has changed, he said. Allspring oversaw $547 billion of assets as of June 30, according to its website.

Beach Point Capital Management has been increasing allocations to multiple kinds of agency mortgage bonds, drawn to wide spreads. Some types of MBS in particular stand out to the California-based firm, including floating-rate MBS backed by Ginnie Mae, which last month were at or near their highest spreads on record, including during the 2008 financial crisis, according to Ben Hunsaker, a portfolio manager.

“For the first time in 10 years, higher return seeking credit funds like ours have been loading up the boats up in agency MBS,” he said.       

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