Robin Marshall
This insight seeks to explain the recent divergence in RMBS spreads amid the Fed's quantitative tightening and frozen mortgage issuance. While mortgage originations remain at historic lows due to elevated rates, agency RMBS spreads have widened to near-decade highs.
- Agency-RMBS spreads versus Treasuries and credit remain near 10 yr highs despite mortgage issuance and strong collateral pricing, defying typical market behavior.
- Fed quantitative tightening and banking stress from 2022–2023 contributed to forced MBS sales, widening spreads further.
- A slow Fed easing cycle would suit agency-RMBS best, but if recession risks force a faster Fed easing cycle, the agency-guarantee offers protection versus corporate credit.
Chart 1: US 30 yr fixed mortgage rates and 10 year US Treasury yield
Source: US Federal Reserve. Data to April 2, 2025. Past performance is no guarantee of future results.
30-year fixed mortgage rates of 6.6% mean very few mortgage holders have any incentive to re-finance existing mortgages, as Chart 2 shows for the different mortgage coupons (for all active fixed-rate mortgage pools from the three agencies). On our calculations, only 5.2% of the remaining principal balance for the three agency mortgages has a gross coupon of 7% or above, giving an incentive to refinance with the current mortgage rate at 6.6%. This means mortgage issuance volume remains depressed, since most existing mortgages were taken out with coupons of 2.5-4% as the chart shows.
Chart 2: Share of mortgages at different gross coupon rates
Source: FTSE Russell Yieldbook. Data to March 2025. Past performance is no guarantee of future results.
But despite low mortgage originations and issuance, strong collateral pricing in the housing market, and the agency-guarantee, agency-RMBS option-adjusted spreads versus US Treasuries remain near multi-year highs, as Chart 3 shows (excluding the Covid yield spike). In addition, although IG corporate credit offers less investor protection with no agency guarantee, higher default risks and no collateral, investment grade (IG) credit spreads have converged to the same spread level versus US Treasuries, as agency-RMBS spreads, as Chart 3 also shows.
Chart 3: 30 yr agency RMBS and IG credit spreads versus 7-10 yr Treasuries
Source: FTSE Russell. Data to March 31, 2025. Past performance is no guarantee of future results.
Further evidence of an apparent anomaly in agency-RMBS spreads is found in the narrowing of non-agency RMBS spreads, like non-Qualifying Mortgages or loans (non-QM) which fully participated in the risk rally since Q4, 2023, with spreads falling steadily versus US Treasuries, as Chart 4 shows. This is consistent with the strong performance of credit generally, and particularly high yield credit. (Non-QM comprise about 15% of the overall non-agency RMBS market, and do not meet the specific underwriting guidelines for an agency guarantee).
Chart 4: Non-QM spreads versus Treasuries
Source: LSEG Yieldbook. Data to end-Jan. 2025. Past performance is no guarantee of future results.
So why are agency - MBS spreads near the highs since Covid?
To explain this apparent anomaly, we need to answer the question why did agency-MBS spreads widen so far in 2022-23, after turning negative in 2021? The Fed’s rapid rate increases in 2022-23, its phased reductions in RMBS holdings in the Quantitative Tightening (QT) programme, and the regional banking crisis in March 2023 all contributed to the spread widening.
In addition, the regional banking crisis drove enforced sales of $114bn in agency-MBS, previously owned by the regional banks SVB and SB, as the FDIC, which assumed control of the failed regional banks’ deposits and assets (via a bridging bank) disposed of these assets in a fire sale. This coincided with the Fed’s ongoing QT programme, which began in May 2022, and included the run-down of its agency-MBS holdings at a pace of $17.5bn monthly, rising to $35bn monthly after 3 months.
Largely due to the low prepayment rate on agency-MBS, and zero incentive to refinance mortgages, the Fed has reduced its holdings by considerably less than the planned $35bn monthly since May 2022, but they are still some $510 bn lower than in May 2022, as the Table 1 shows.
Table 1- Summary of main US Federal Reserve’s System Open Market Account holdings ($ trn.)
| Security type | May 4, 2022 | April 2, 2025 | Total Quantitative Tightening reduction |
|---|---|---|---|
| US Treasuries Notes & Bonds | 4.95 | 3.58 | 1.37 |
| US Tips | 0.38 | 0.32 | 0.06 |
| Agency MBS | 2.71 | 2.18 | 0.520 |
| Agency CMBS | 0.09 | 0.08 | 0.01 |
| Total[1] | 8.4 | 6.30 | 2.10 |
Source: New York Federal Reserve, April, 2025.
Negative convexity and MBS
The pronounced negative convexity of MBS did not help either, in 2022-23, since duration of a bond with negative convexity[2] increases as rates rise. Thus, MBS duration increased as interest rates rose and refinancings began to collapse, as Chart 5 shows. Now however, the negative convexity of 30 yr agency-RMBS is close to zero, as Chart 5 shows, and the Fed has embarked upon a slow easing cycle, so interest rate volatility has fallen sharply, reviving the appeal of RMBS, ceteris paribus.
Chart 5: Convexity and duration of 30 yr UMBS
Source: FTSE Russell, Yieldbook, data to March 2025. Past performance is no guarantee of future results.
A slow easing cycle with low interest rate volatility may favour agency-MBS?
It can be argued a slow Fed easing cycle with low-rate volatility is the most favourable for MBS as a fixed income asset. This is because a faster decline in rates could boost mortgage issuance, as new buyers enter the market, and existing mortgage holders increase refinancing, as mortgage rates fall to low enough levels to give an incentive to do so.
…..and even a recession & faster easing cycle may carry greater risks to credit
The combination of a slow easing cycle, RMBS spreads near 10 yr highs versus credit, the likelihood of subdued RMBS issuance and the agency guarantee are all factors suggesting spreads are anomalously high versus high yield credit particularly. Indeed, even if the Fed is forced to accelerate easing because of recession risks, the agency-guarantee should offer strong RMBS support versus credit. It is true that in this scenario, a recession could also impact house prices via increased unemployment, mortgage delinquencies, and repossessions, but note that underwriting standards on mortgages were tightened significantly after the GFC, and US homeowners have much higher levels of equity in housing than in the GFC, as Chart 6 shows. Another risk would be that US banks reduce RMBS holdings further, should loan growth accelerate, and capital adequacy regulations ease.
Chart 6: US house-owners’ equity in real estate
Source: US Federal Reserve (latest data to Q4, 2024). Past performance is no guarantee of future results.
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