Why Are Fixed Income Managers Staring at SOFR Rates and Why Does Their Coming Down Matter?

It seems that there is a shift in markets and that fixed income investors, at least the large institutions, are beginning to allocate in large volume to Mortgage Backed Securities (MBS). With the hopes (or promise) of a rate cut in September, these investments could produce outsized yields relative to the short-end of the curve with essentially zero credit risk because they have what amounts to a government guarantee.

Buyers with yield sensitivity seem to like this trade because risk premiums are generous compared to corporate bonds and other credit markets. If rates were to come down, this may bring US banks back into a market they used to dominate and could lead to generous price increases. Despite the government protection and backing, agency MBS have fallen short of corporate bonds, loans, and other large liquid asset classes on a total return basis. Compared with a year ago, spreads have narrowed but are still well above their average from the last 10 years or so.

The debt's prospects depend in part on US commercial banks, which owned as much as 30% of the entire market two years ago when the Fed started tightening policy. But when rising rates led to bank depositors piling into money market funds with high yields, lenders had to reallocate to shorter-term duration from longer duration assets like MBS.

Lower rates will adjacently benefit MBS because they will also cause bank deposits to rise and thus cause banks to deploy their assets into longer duration assets and securities like MBS. Spreads are likely to compress as a result. All the while, prices of MBS and fixed income debt should rise as rates fall.

You can see evidence of this thesis while looking at the holdings of some of the largest bond funds on the market. Consider the PIMCO Total Return Fund. At the end of June (Q2), they held 65.39% of their fund in Agency MBS and another 27.93% in non-agency MBS. This is by far their largest position and the others are not even close! (PIMCO Income Fund INST - PIMIX - PIMS). For comparison, this is nearly 13% more than the AGG Index holds. The Doubleline Total Return Bond Fund holds over 40% in agency RMBS and another 25% in NARMBS. (DoubleLine-Total-Return-Bond-Fund-Fact-Sheet.pdf).

The key thing to keep track of is the Fed Funds Rate and the daily SOFR rate, which is a key metric for things like excess interest, credit support, and spreads.