The outlook for mortgage-backed securities

Jeff Rosenberg discusses what the Fed’s balance sheet normalization could mean for this fixed income sector.

The Federal Reserve (Fed) indicated earlier this month that its balance sheet reduction would start this year. One fixed income sector likely to be particularly affected by this normalization process: mortgage-backed securities (MBS).

Housing was at the core of the financial crisis. To curb this crisis, the Fed bought some $1.8 trillion in mortgages. MBS yield spreads to Treasuries—a proxy for home borrowing costs—have slumped back to pre-crisis levels, in line with the expansion in the Fed’s holdings, as the Good for homeowners chart below shows.


We believe this has diminished their traditional attractiveness as an alternative to Treasuries that provides similar default-free risks but with higher income.

A normalization of the Fed balance sheet would likely involve eliminating most of the central bank’s MBS holdings over time. MBS valuations today reflect anticipation that this process will go smoothly—as well as benign expectations that rates will rise only gradually. These expectations are not limited to MBS—credit spreads as well stand at or close to post-crisis tight levels. This leaves little margin for error, we believe, and is reflected in our neutral stance on MBS and preference for higher-quality credit in today’s environment.

However, this is the first time the Fed has ever used asset reductions as a tightening (or normalizing) tool, making the actual impacts uncertain. As such, the Fed is likely to proceed cautiously with its unwinding. Read more in my full fixed income strategy piece Crossing the river by feeling the stones.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today’s environment.

Investing involves risks including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

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