(Bloomberg) — As rising energy prices and growing inflation fears make corporate bonds look increasingly risky, big money managers including State Street and Voya Investment Management have been looking at buying mortgage bonds and other securitized debt instead.
Mortgage bonds often perform better than US high-grade corporate debt in “risk off” markets where investors are becoming more fearful, wrote Spencer Rogers, strategist at Goldman Sachs, in a note this week.
The debt is getting extra support now from Fannie Mae and Freddie Mac, after US President Donald Trump in January directed the companies to buy another $200 billion of the bonds. It’s worth looking at mortgage bonds that might perform better if rates fall again, Rogers wrote. For instance, purchasing specified pools designed to protect against higher prepayment speeds means investors can hang on to those cashflows for longer as rates fall.
Meanwhile, there’s ample reason to be worried about corporate debt. Crude oil futures have surged amid the US and Israeli attacks on Iran, and Iran’s retaliation on energy sites in nearby countries. West Texas Intermediate futures topped the $95-a-barrel range this week, compared with $57.42 at the end of last year. Prices in other markets are rising even more. Higher energy prices can effectively act as a tax on manufacturers and consumers, and can weigh on profits.
Higher oil prices may also make it harder for the Federal Reserve to continue cutting rates. On Wednesday, Fed Chair Jerome Powell said that central banks usually view higher energy prices as transitory, but inflation has been above the Fed’s 2% target for five years, implying that the central bank has less leeway to dismiss higher oil prices now. Bond traders are no longer pricing in any US rate cuts this year.
If rates stay higher for longer than expected, corporate profits could be hit as future borrowing costs rise. That’s at least part of the reason that US high-grade corporate bond spreads have widened by about 0.17 percentage point from their Jan. 22 lows. It may also be part of why the bonds have lost value this year on a total return basis.
Mortgage bonds, meanwhile, have gained a bit, according to Bloomberg index data. The securities look attractive from a relative value standpoint compared with corporate bonds, said Matthew Nest, global head of active fixed income at State Street Investment Management.
The gap between the current production mortgage bond spread and the high-grade corporate bond spread was around 0.33 percentage point as of Thursday’s close, according to Bloomberg index data. The average gap during the last decade was negative, because current coupon mortgage bond spreads have tended to be tighter than the high-grade corporate bond spread. By that standard, MBS are relatively cheap.
It makes sense to avoid credit risk in this part of the cycle, according to Nest. Mortgage bonds are more closely correlated with interest-rate fluctuations, and a measure of that volatility has been declining in recent days. The firm has been overweight mortgage bonds and other securitized debt relative to benchmarks for much of the past year.
“Late cycle, securitized debt tends to seem attractive,” State Street’s Nest said.
There are risks to the trade of favoring mortgage bonds and other securitized debt over corporate debt. The moment the war in Iran ends, or the Trump administration pulls back from the conflict, high-grade credit spreads could snap back quickly, narrowing 0.2 percentage point, said Tony Trzcinka, portfolio manager at Impax Asset Management.
“If we’ve learned anything from the past year, it’s that this administration will do everything in its power to provide a floor on markets,” Trzcinka said.
On top of that, many markets in the coming months may end up being driven by oil prices. As long as energy prices create inflationary pressure, and doubt about the future direction of rates, both corporates and mortgage bonds could be hit, said Brian Quigley, senior portfolio manager and head of MBS and agency debt at Vanguard.
“I think you need to be really careful with what correlation you’re assuming between MBS and corporate bonds at the moment,” Quigley said. While over a long period of time the two tend to have a low but positive correlation, the connection between them may be closer than usual in the near term, he said.
But credit faces other pressure too, including artificial intelligence disrupting software companies, and private credit potentially facing growing losses. Those factors had been weighing on corporate bonds even before the US and Israel first attacked Iran.
Given those risks, it might make sense to favor MBS and other securitized debt over corporate bonds, said David Goodson, managing director and head of MBS at Voya Investment Management.
“In a world like we have today, MBS offers an appealing source of diversification,” Goodson said.
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