Reserve managers seeking to diversify their foreign currency holdings could consider investing between 5–10% of their assets in mortgage-backed securities (MBS), according to a central banker and two asset managers participating in a Central Banking webinar, Portfolio Diversification for Central Banks: Are Mortgage Backed Securities (MBS) a good idea?.
Such an allocation could be even higher for a large reserve manager with assets well in excess of those required to meet urgent coverage ratios – although liquidity constraints may hamper participation in the market for the very largest reserve managers, such as China and Japan, which have more than $1 trillion in assets to place.
"Central banks are concerned about liquidity and capital preservation, with income generation as a third add-on," said Raivo Vanags, member of the board and head of market operations at Bank of Latvia. "Agency MBSs offer all three components: they offer yield stability, they offer liquidity and they compensate you for some of the additional risk that you take on. Also, they have also proven to be very stable over the years compared with other assets in the fixed income universe."
Ulrik Walther, senior vice-president and head of Europe, Middle East and Africa sovereign business at Pyramis Global Advisors agreed. "They tick all three boxes – security, liquidity and return – that makes them eligible for consideration in a central bank world," says Walther. "But there are also risks there that need to be thought about and understood before one embarks on an MBS programme."
These risks include those embedded in the underlying mortgages, the risks associated with the securitisation structure used to create an MBS, as well as the risk related to any guarantees on payments by ‘agencies' and other parties. Agencies such as Fannie Mae and Freddie Mac, which gained temporary US government support when they entered ‘conservatorship' in 2008, guaranteed some $5.7 trillion of the notional outstanding of US MBS as of the first quarter of this year.
"From a central bank perspective, we feel quite strongly that [an allocation] should be based on agency," said David Smart, global head of sovereign funds and supranationals at Franklin Templeton Investments. "Once you go outside of the agency area you have to take on a significant degree of care and research in terms of what one is investing in. And I think the liquidity is significantly questionable. The last thing that central banks want to do is get stuck in some relatively illiquid securities that have got some sort of credit issue."
The private MBS market in the US had a notional outstanding of $1.25 trillion, according to first quarter of 2013 figures, about a quarter the size of the agency market. Walther, meanwhile, said the covered bond market outside of the US is about €2.4 trillion in size across 28 countries. "The credit risk inherent in an agency mortgages is much, much smaller than in the private market," Walther added.
Vanags said the Bank of Latvia's investments are currently all in agency securities. However, the central bank has an external mandate that allows "managers to deviate and invest in private pools". "But from a practical point of view, managers are not that keen to go out and buy private securities. They would rather express their views on agency securities," he added.
Even agency investments can prove tricky. The US government is reviewing the conservatorship status of the mortgages agencies, with the result still far from clear. Moreover, Federal Reserve buying activity is distorting the shape of the MBS market.
In addition, prepayments "haven't been happening at quite the rate that you would expect them to happen", said Smart. "There are a fair number of people whose mortgages are worth more than their homes and they cannot refinance. There is a backlog of refinancing."
Vanags said there are concerns about negative convexity from prepayment risks - which means that when interest rates rise MBSs behave like long-term bonds and their prices fall but when rates fall MBS prices rise slowly or not at all - but that MBS "offer a nice yield pick-up", adding "there is no such thing as a free lunch". "MBS are a nice diversifier and give additional stability. If the rates move in opposite directions sometimes it smooths out your earnings and that is what we like about them," Vanags said.