As US Treasury yields climb to multi-decade highs, investors are pulling money out of US mortgage-backed securities (MBS) funds on a massive scale.
Over the past three weeks, outflows from these funds have ranked among the seven worst since early 2021, a reflection of how violent rate swings are pushing investors to rapidly exit riskier fixed-income assets.
Data shows the Bloomberg US Mortgage-Backed Securities Index recorded its second-worst monthly performance on record in September.
Previously, driven by surging oil prices, intensifying inflation worries and expectations that the Federal Reserve will raise rates further, US Treasuries suffered heavy selling that sent yields steadily higher, placing enormous pressure on the mortgage bond market.
Mortgage-backed securities are especially sensitive to sudden moves in bond yields, because US Treasury yields serve as a key pricing benchmark for borrowing costs across the entire economy.
When market rates rise, homeowners typically scale back mortgage refinancing activity, since converting an existing low-rate loan into a new one becomes less attractive.
That means prepayments on the underlying mortgages slow, forcing MBS investors to hold relatively lower-yielding securities for longer and exposing them to greater interest rate risk.
Erica Adelberg, a senior MBS strategist at Bloomberg Intelligence, said Fed monetary tightening and a flattening US Treasury yield curve could weaken bank demand for mortgage-backed securities, even though banks have long been major buyers in this market.
Still, Adelberg noted there are some positive factors at play.
With mortgage rates rising to their highest since 2023, mortgage refinancing and home purchase demand may weaken further, driving MBS supply steadily lower through year-end.
At the same time, higher mortgage rates could also curb the pace of growth in home prices and loan sizes, further limiting the supply of newly issued mortgage-backed securities.
It is worth noting that the September selloff in the US Treasury market has pushed long-term Treasury yields to their highest level in 24 years.
Meanwhile, the excess return performance of mortgage-backed securities relative to US Treasuries has remained persistently weak, further dragging down total returns for the asset class.
Adelberg said that, taken together, these factors have pushed the year-to-date total return of the Bloomberg US Mortgage-Backed Securities Index to its second-worst level in its 50-year history.
Although reduced MBS supply before year-end may offer some support to the market, against the backdrop of further Fed policy tightening and Treasury yields staying elevated, weak bank demand and rate volatility remain the main challenges facing the mortgage bond market.
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