With several months of 2025 now behind us, the portfolio strategy outlook for the year has—hopefully—become somewhat clearer. At the time of this writing, the five-year Treasury rate is approximately 60 basis points below its high of 4.62% from January, which is below the highs of roughly 5.00% and 4.75% seen in 2023 and 2024, respectively. Though it may not feel like it, the five-year has been relatively stable between 4.00% and 4.50% for much of the past two and a half years; more than half of the daily closing levels have been within this range since September 2022.
A useful measure for assessing relative value within the bond market is spread over Treasuries. Simply put, Treasury spreads measure the additional compensation investors require to own some type of risk.
The form of this risk may vary. Corporate bonds carry credit risk but feature relatively certain cash flows, while agency mortgage-backed securities (MBS) feature minimal credit risk but carry greater uncertainty around the timing of cash flows. Though the risk profiles may differ, the spread over benchmark Treasury rates—and more importantly, how those spreads have moved over time—can be informative for determining which investments might be attractive at any given point in time.
What’s so great about agency MBS?
While heightened volatility can rear its head at a moment’s notice, the period of relative stability referenced above generally coincides with a decline in Treasury spreads. No sector has been completely immune, but agency MBS stands out as one sector that still looks attractive relative to historical precedent.
As shown in the chart on the right, the Treasury spread in agency MBS has come down off its absolute high, but held in remarkably well even as spreads declined in investment-grade corporates and agency-guaranteed commercial MBS. Among the sectors shown in the chart, MBS is the only one where Treasury spread remains above its average over this entire period.
One possible reason for the persistence of above-average Treasury spreads in agency MBS is limited purchase activity from depository buyers. This could be driven by several factors: a decline in portfolio cash flow because of higher interest rates, limited liquidity due to competitive pressures on the deposit side, a simple reluctance to step back into the space after portfolio mark-to-market became problematic, etc.
But regardless of the reason behind it, there are several ways that management teams can take advantage of the opportunity. The vast majority of agency MBS is composed of mortgage loans carrying a 30-year final maturity. While such a long time frame for repayment may give some managers pause, pools with a 20-year final maturity capture much of the same relative value with a payment profile that is considerably shorter. In addition, collateralized mortgage obligations (CMOs) can be built off of 30-year MBS to shorten the cash flow profile while keeping the strong relative value.
Different time and circumstances
For those who might have sworn off agency MBS or CMOs after a bad experience while interest rates were rising, I’ll utter one of the most dangerous phrases in finance: It’s different this time. Yes, MBS still feature the same basic structure of pooling mortgage loans and passing through a pro rata portion of monthly principal and interest payments. However, it’s important to remember that the MBS being issued today have very different performance characteristics than the ones issued several years ago.
At the time of this writing, Fannie Mae’s 30-year current-coupon index—which tracks the hypothetical coupon rate on a new-issue 30-year MBS pool priced at $100—sits at roughly 5.5%. If purchased at par, a new-issue 30Y 5.5% MBS models with a price decline of roughly 15% in a +300 basis point shock scenario.
In the depths of the pandemic, the 30-year current-coupon index bottomed out at 1.18%. Though issuance in coupons below 2% was limited, more than $2 trillion of agency MBS with coupon rates of 2.5% or lower remains outstanding.
In contrast to the 15% price decline referenced above, pools issued during this time frame often carried +300 price declines of 20% or more. While these are structurally the same securities, the fact that coupon rates are much higher today provides a degree of insulation that simply wasn’t present when interest rates were lower. When paired with a more normalized interest rate environment, that added insulation greatly reduces the likelihood of repeating the extreme levels of price decline that MBS investors experienced as interest rates rocketed higher.
As interest rates have found some level of stability over recent years, Treasury spreads in many sectors have moved below their longer-term averages. Agency MBS has remained an exception to this broad-based tightening, creating a pocket of relative value for community bank portfolio managers. Though the memory of severe price swings may linger for previous investors in the space, the differences between today’s MBS and those of the past mean that the sector may be worth another look.
