• MBS should continue to offer an attractive risk-adjusted return opportunity in 2013.

• The primary fundamental positive for agency MBS lies in low overall refinancing risk.

• However, as interest rates remain low and home prices gradually increase, security selection will be of paramount importance.

Agency mortgage-backed securities (MBS) should continue to offer an attractive risk-adjusted return opportunity in 2013, as the technical and fundamental backdrop remains favorable, resembling 2012 in many aspects. From a technical standpoint, we expect the Federal Reserve (the Fed) to continue MBS asset purchases for much of the year, thereby extending the positive supply/demand dynamic that has been in place since the Fed announced the third round of quantitative easing (QE3) on September 13.

The primary fundamental positive for agency MBS lies in low overall refinancing risk, which is likely to remain muted versus historical standards. Three main factors lead us to believe refinancing activity will remain below the historical pace:

1. The cumulative decline in home prices since the 2006 peak. Despite recent signs of recovery in home prices, approximately 22% of all outstanding mortgages remain underwater; that is, the mortgage loan balance exceeds the property value.* Underwater borrowers are limited in their ability to refinance because the loan is insufficiently collateralized by the underlying property.
2. Historically tighter lending standards. The persistent tightening of lending standards has created an environment where only borrowers with strong credit profiles qualify for a mortgage.
3. Reduced capacity among mortgage lenders.

Nevertheless, with the Fed maintaining low interest rates through 2015 and home prices forecast to recover modestly in 2013, it is likely there will be a small increase in refinancing activity. At Columbia Management, we look to mitigate the potential for increased refinancing risk through rigorous, bottom-up security selection that focuses on finding securities that deliver the best risk-adjusted returns for investors.

Compensation for volatility: maximizing risk-adjusted returns

In the current environment of compressed risk premiums across all fixed-income asset classes, it is imperative that investors seek out strong risk-adjusted returns; that is, returns that compensate them for the additional level of risk incurred. Historically, MBS have generated the most attractive risk-adjusted returns within the investment-grade fixed-income universe, as measured by the Sharpe ratio (see chart, below). The Sharpe ratio measures how well the return of an asset compensates the investor for the amount of risk taken. Given the strong technical and fundamental position of the sector, we expect MBS to continue to offer attractive risk-adjusted returns throughout 2013.

Favorable MBS supply/demand: Negative net supply with a lot of Fed buying

MBS supply will be limited in 2013, as the vast majority of qualified borrowers with sufficient economic incentive have already refinanced into lower rate mortgages. Market expectations are that the net supply (gross issuance minus pay-downs and refinancing) of MBS will be negative $25 billion.** Meanwhile, the Fed, as part of QE3 and Operation Twist, has committed to an open-ended MBS purchase program of $65 billion per month. That brings its potential 2013 MBS purchasing power to $800 billion, or 60% of gross issuance. It is also worth noting that the Fed is a noneconomic buyer of MBS, and their purchases tend to be very consistent and structured, regardless of valuation.

Conclusion: Environment favorable, but security selection will differentiate

Given the considerable challenges in the current environment, with low rates and compressed risk premiums, we believe that MBS offer an attractive risk-adjusted return opportunity. The confluence of a negative net supply, continued support from the Fed, tight lending standards and a large decline in home prices create a favorable fundamental backdrop for MBS investors that can differentiate among investment opportunities through bottom-up security selection. We expect a broad divergence in MBS performance, as interest rates remain low and home prices gradually increase. As a result, security selection will be paramount in 2013.

See more Market Insights from Columbia Management.

*Source: CoreLogic, 2012.

**Source: Columbia Management, 2012.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.