The Federal Reserve is widely expected to complete its bond purchase program – the third round of quantitative easing, known as QE3 – at the end of October. Once completed, the Fed will have purchased a cumulative $2.925 trillion in bonds since the first round of QE began in 2008 and expanded its balance sheet holdings of mortgage-backed securities (MBS) to $1.725 trillion. The Fed now owns more than a third of all outstanding agency-backed mortgage securities and has created a historically expensive mortgage market in the process of spurring significant refinancing activity.
It is hard to dispute the Fed’s success in this regard. Home prices have increased 21% in the last two years, mortgage rates remain near all-time lows and over 3.2 million borrowers have refinanced through the Home Affordable Refinance Program (HARP). A total of 19.6 million borrowers have refinanced through Fannie Mae and Freddie Mac thanks to the Fed’s accommodative policies.
However, the Fed’s efforts have also created material distortions and confusion in the world of benchmarked fixed income management – particularly now since recent speeches by Fed members have suggested that the Fed may never sell its MBS holdings.
If a bond is created and then sold to the Fed, does it really exist?
The answer to this question depends on whom you ask. Those who manage Treasuries against the Barclays U.S. Aggregate Index (BAGG) would say the answer is no. But those who manage mortgages against the BAGG would say the answer is yes. That is because the index excludes Treasuries that the Fed purchases but includes the mortgages.
Why? It is not because the size of the Fed’s Treasury holdings is so large that no manager could manage to an index that included Fed holdings. The Fed actually owns a significantly larger percentage of MBS than Treasury securities relative to the total outstanding universe. In fact, while the Fed owns 24% of outstanding Treasuries, it owns a far larger 37% of the outstanding agency fixed-rate mortgage universe (see Figure 1).
The decision to exclude Fed holdings from Treasury indexes predates quantitative easing programs. When the Fed began purchasing agency MBS in 2008, many investment firms supported Barclays’ decision to include Fed-owned agency MBS in the index, even though Treasuries were excluded. PIMCO agreed with this decision at that time because the Fed’s agency MBS purchases were communicated to be temporary. The Fed planned to buy mortgages (only $500 billion), and then shortly thereafter allow them to run off naturally by not reinvesting principal repayment, and eventually taking its position to zero in three to five years via outright sales.
The Fed’s rhetoric and apparent plans have recently changed. Fed speeches now suggest the Fed may never sell its MBS holdings, and only after raising interest rates will it allow the mortgages in its portfolio to run off (that is, end reinvestments).
Why should investors be concerned?
The inconsistent approach in the index is detrimental to investors because they are being asked to hold historically expensive securities that are limited in availability. Additionally, unlike with Treasuries, the Fed will not lend agency MBS that have settled on its balance sheet. Within the Treasury market, if an issue is in short supply and it is financing special in the repo market, the Fed will lend its Treasuries to ease the squeeze. This is not the case with agency MBS; once the Fed has taken delivery of a security, that bond is gone forever.
There is no explicit or public relationship between Fed policy and the BAGG’s composition, but the inconsistent index approach had the unintended consequence of supporting Fed policy over market functioning and liquidity. Some argue that this unintended consequence has lowered mortgage rates, but PIMCO would argue that if MBS were to be removed from the index and mortgage valuations were to revert to our view of fair value, mortgage rates would only rise 14 basis points.
We think the Fed’s objective is actually better served by excluding MBS from the index; exclusion today creates demand tomorrow, if and when the Fed decides to exit. As the Fed either sells bonds or simply lets current holdings amortize without reinvesting paydowns, those bonds will re-enter the indexes and create natural demand to cushion the exiting of its extraordinary measure of QE.
How to fix the problem?
While the inconsistencies are clear, the next question becomes: In order to right this wrong, should MBS be excluded, or Treasuries included, from the BAGG?
We believe the index is best aligned through the removal of agency MBS held by the Fed. Investors choose indexes because they are looking to capture the beta of a given sector. With over a third of the index “beta” permanently held on the Fed’s balance sheet, the universe is not truly available or replicable, and the returns investors are seeking to capture are not representative of the asset class, but directly manipulated by the Fed’s policy.
Our final exaggerated hypothetical: Should MBS be excluded from the index if the Fed owned 100% of all agency MBS outstanding? We think that most investors would agree that MBS should be excluded. Therefore, we are simply disagreeing on the threshold at which to remove an asset class from the BAGG: We believe the MBS threshold is less than 37%, and the market effectively believes the Treasury threshold is less than 24%.
As market participants consider and debate this issue in the wake of the Fed’s new policy stance, we believe this is an issue that needs to be readdressed to bring consistency to the index. While we expect that investors would benefit from the exclusion, we believe all index investors benefit when the indexes we are managing to reflect the actual markets less Fed distortions.
In the meantime, at PIMCO we are employing active management across our fixed income complex, generally reducing exposure to the mortgage bonds that have been made the most expensive by the Fed. We believe this is another example of the long-term risk/reward benefits of active management.