Bright Meadow, a Mariner investment team, discusses refinancing risk, the Fed’s balance sheet unwind, and why agency MBS remains an underrepresented – and uncorrelated – asset class across hedge fund portfolios.
Adam Rilander is the Managing Partner, CIO and Head of Agency MBS (mortgage-backed securities) at Bright Meadow, an investment team within Mariner Investment Group.
Despite comprising a $9tn market, Agency MBS remains a frequently overlooked and misunderstood asset class. Rilander attributes this directly to an information gap. “I believe that across the market, there is a fundamental lack of understanding about the asset and the dynamics of the industry. That is one of the primary barriers to entry for capital deployment. We spend as much time educating investors about the market as we do investing in it.”
Agency MBS is one of the largest and most liquid fixed-income markets globally. At its core, an Agency MBS asset is a security backed by a pool of U.S. residential mortgages, with a guarantee of receiving principal and interest back from one of the three main U.S. government-affiliated entities: Ginnie Mae, a true government agency that guarantees MBS issued by approved private lenders and backed by federally insured loans; Fannie Mae, a government-sponsored enterprise (GSE) that purchases conventional mortgages from lenders and packages them into MBS, and; Freddie Mac, also a GSE, that purchases conventional mortgages, but from smaller lenders than Fannie Mae, and securitises them into MBS. Because these guarantees eliminate default risk, the primary risk in Agency MBS is not credit, but prepayment – specifically, the borrower’s right to repay their mortgage early, returning capital to investors at an inopportune time.
During the 2000s, large amounts of capital flowed into the Agency MBS market. However, after the GFC, the Fed stepped in and absorbed trillions of dollars in mortgage-backed securities to stabilise the housing market and push mortgage rates lower. While these measures were intended as emergency interventions, they ultimately left the Fed holding roughly $2.7tn of MBS on its balance sheet.
By the time Adam joined Mariner in 2016, Agency MBS was an enormous market, but also an incredibly complex one. “The space had seen a big boom after the GFC, but mortgages had gotten too rich, and many managers stopped trading agency mortgages in a hedge fund approach. That created a real opportunity. We believed there were still highly profitable, genuinely differentiated ways to generate cash flows that simply don’t correlate with the rest of an investor’s portfolio. That differentiated profile is at the core of what we do.”
The Fed has gradually begun reducing its MBS holdings from the $2.7 trillion peak, which Rilander believes sends both hawkish and dovish signals on interest rates and, as a result, prepayments and new mortgage origination. “As the Fed gradually unwinds its position, mortgages should be on the cheap side. Investors could see compelling cash flows for a long time, particularly in cheap government or quasi-government guaranteed instruments. That’s going to be a very interesting opportunity for us.”
While interest rates remain the primary driver of refinancing activity, a secondary driver is the growing role of automation. AI-enabled platforms can continuously monitor interest rates, calculate potential savings and simplify the documentation process. This could enable borrowers to secure better refinancing deals. Rilander identifies this as a balancing act for the Bright Meadow Team, given there is a structural risk that requires continuous model monitoring and readjustments. “Ensuring that we adjust to ongoing improvements in a borrowers’ ability to refinance is going to be challenging for prepayment-sensitive mortgages going forward.” He also notes that more efficient refinancing ultimately pushes mortgage rates higher, as bondholders price the increased prepayment risk into required yields.
Despite the compelling opportunities – and pricing dislocations that can be exploited by investing in Agency MBS – Rilander says the asset class remains “underrepresented in a hedge fund allocator portfolio. “Many institutional investors have not meaningfully re-engaged with the asset class since returns compressed in the aftermath of the GFC. However, unlike many other asset classes, Agency MBS does not carry a positive correlation to the broader economy. For investors whose portfolios tend to converge in downside scenarios, that is an important distinction.” The complexity that deters many allocators is, in his view, exactly what sustains the opportunity. “If it were easy, the returns would probably be lower.”
