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Looking for a place to hide out if volatility returns? Favor agency MBS over IG corporates

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By Chip DriscollInstitutional Portfolio Manager, Eaton Vance Management

Boston - Risk assets have rebounded nicely in recent weeks, though they have only partially recovered from their substantial first quarter sell-off. Through May 12, stocks are still 13% off their February highs, and investment grade (IG) corporate bonds are nearly 6% below their recent peak.

The coronavirus-induced market collapse that began in late February has likely scarred many investors. Not only was it one of the fastest corrections in stock market history, but it was even more challenging in that many other asset classes often expected to buffer against downside risk were also not spared. For example, IG corporates, which typically represent the core of many investors' fixed income allocations, ended March down 7.5%, making that the worst month for the ICE BofA US Corporate Index in more than 20 years.

With the US economy probably heading for its sharpest decline in growth since the Great Depression and the potential resurgence of COVID-19 fears in months ahead, many investors may be asking themselves where to hide out if volatility strikes again. We believe the answer to that question can be found in the agency mortgage-backed securities (MBS) market.

Positive returns when stocks fall

As they have done in the past, agency MBS have once again provided investors with downside protection and positive returns amid the most recent equity market volatility. Despite the S&P 500 Index falling by nearly 20% in the first quarter, agency MBS finished up 2.8%.

Further, consider that there have been 14 quarters in the past 20 years when stocks fell by more than 5%. During those periods, agency MBS posted positive returns 100% of the time, averaging total returns of nearly 3% per quarter. Compare this with IG corporates, which were positive only 64% of the time, with an average return of less than 1%.

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Greater liquidity and higher quality

We believe the superior downside protection historically offered by agency MBS is the result of two factors. First, the agency MBS market represents the second most liquid fixed income market in the US — over $300 billion in agency MBS are traded every day — so there is limited liquidity risk. Corporate bonds are less liquid by comparison, with less than $40 billion in average daily trading volume, which may result in greater pressure on the sector during periods of forced selling, as was the case in the first quarter.

Second, and perhaps more importantly, agency MBS carry AAA-ratings owing to their being guaranteed by the US government, so there is effectively no credit risk. By comparison, the IG corporate bond index has less than 2% in AAA-rated securities and more than 47% in BBB-rated securities.

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Bottom line: If we do see a steep drop in economic growth in the quarters ahead and a slow recovery thereafter, concerns about potential downgrades, solvency issues and liquidity pressures in the corporate bond market may return. Agency MBS, on the other hand, may be able to shield investors from many of those fears and offer a safer place to hide out from the volatility.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.