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In baseball, now is the time that the teams are looking to October. Managers are making trades, calling up talent from their farm teams and reshuffling rosters in hopes of getting the depth and breadth of skills they’ll need to reach the playoffs. It takes more than all-stars to get there. They need the utility players they can count on for singles and doubles. The same principles are at work in diversified bond portfolios. Asset classes that may deliver the highest return in any one year are often the same that in another year may turn in the worst results.
MIDDLE OF THE PACK.
To wit, consider the “quilt” chart (below). It ranks the annual returns of a wide range of bond sectors from best to worst for the past decade. Performance has varied widely, with no single sector dominating year after year. Note, certain sectors—notably longterm US Treasuries and high yield—often show up either at the top or bottom of the list. “Long Treasuries” delivered top results in four of the past 10 years but have also ranked at the bottom as many times. In contrast, the mortgage-backed securities (MBS) sector and the investment grade corporate bond sector fall consistently in the middle. In fact, the MBS sector has not finished in the bottom quartile of the return rankings in the past decade.
Mortgage-backed securities are fixed income investments, created by packaging together pools of mortgages with similar characteristics. They represent an ownership interest in a pool of residential mortgage loans. These pooled payments are then “passed through” to MBS holders in the form of principal and interest cash flows. MBS are offered by government agencies, and principal and interest is guaranteed by the government or those agencies. The market is large and diversified, offering a variety of estimated maturities and coupons. MBS make monthly income payments (of principal and interest), rather than semiannual payments. This provides investors with more frequent reinvestment opportunities as well as steady income.
SEEKING QUALITY. Mortgage-backed securities have also tended to outperform in environments in which investors seek quality, liquidity and monthly cash flow. In 2008, despite the bursting of the housing bubble and a continuous drumbeat of bad news about mortgages, the MBS sector outperformed investment grade corporate bonds by more than 11 percentage points as investors sought shelter in the highest-quality, most liquid assets. In 2011, when spreads generally tightened and returns were generally positive, MBS tended to outperform similar-maturity Treasuries but lag credit-sensitive sectors. In periods of economic and interest rate stability, MBS provide a source of income and return. Historically, the chief risk to MBS is markets in which interest rates become highly volatile, either up or down, as the owners of MBS hedge their prepayment risk. In recent years this dynamic has been muted, as the largest MBS holder—the Federal Reserve—is more liable to hold them than to trade them. In 2013, MBS performed relatively well despite the sharp increase in rates.
We believe a strategic allocation to MBS within a broad fixed income portfolio could add incremental value over time. MBS are an attractive, higheryielding alternative to similarly rated bonds and have been a means of dampening the volatility associated with the credit component of a fixed income portfolio.
Please see Important Article Disclosures
© 2015 Morgan Stanley Smith Barney LLC. Member SIPC.
CRC 1277397 8/15
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