Mortgage Bonds Gain Favor as Corporate Debt Risks Rise Amid Inflation Fears
State Street and Voya Investment Management are shifting assets away from corporate bonds and toward mortgage-backed securities (MBS) as concerns mount over potential defaults triggered by rising energy prices and geopolitical instability, particularly in the Middle East. The move, reported Saturday, reflects a growing apprehension among major financial institutions regarding the deteriorating credit outlook for corporations.
Crude oil futures have surged in recent weeks amid escalating tensions involving the U.S. And Israel and Iran’s retaliatory actions, topping $95 a barrel – a significant increase from $57.42 at the end of last year. This spike in energy costs is viewed as a potential drag on corporate profits, effectively acting as a tax on both manufacturers and consumers.
According to a note from Goldman Sachs strategist Spencer Rogers, mortgage bonds often outperform U.S. High-grade corporate debt during “risk off” market conditions. This assessment is further supported by a $200 billion bond-buying directive issued in January by President Donald Trump to Fannie Mae and Freddie Mac, providing additional support to the MBS market.
Matthew Nest, global head of active fixed income at State Street Investment Management, highlighted the relative attractiveness of MBS compared to corporate bonds. As of Thursday, the gap between current production mortgage bond spreads and high-grade corporate bond spreads stood at approximately 0.33 percentage points, a divergence from the historical average where MBS spreads were typically tighter. Nest stated that it “makes sense to avoid credit risk in this part of the cycle.”
The shift in strategy is not merely a tactical adjustment, but a structural reassessment of risk, according to Voya Investment Management managing director and head of MBS, David Goodson. “In a world like we have today, MBS offers an appealing source of diversification,” Goodson said.
However, the transition is not without potential pitfalls. Tony Trzcinka, portfolio manager at Impax Asset Management, cautioned that a de-escalation of the conflict in Iran or a policy shift from the Trump administration could lead to a rapid narrowing of high-grade credit spreads. He also noted the potential for government intervention to prop up markets, as seen in the past.
Brian Quigley, senior portfolio manager and head of MBS and agency debt at Vanguard, warned against assuming a strong correlation between MBS and corporate bonds, particularly in the current volatile environment. He emphasized the need for caution, given the potential for both asset classes to be negatively impacted by sustained high energy prices and uncertainty surrounding interest rate policy.
Beyond geopolitical risks, concerns are also growing regarding the impact of artificial intelligence on the software industry and potential losses within the private credit market. Morgan Stanley anticipates a rise in default rates in direct lending to 8% as AI continues to disrupt the software sector.
Despite these concerns, some firms are exploring opportunities within the private credit space. Sumitomo Life Insurance Co. Is considering allocating approximately $1.9 billion to private credit in the upcoming fiscal year, while Oak Hill Advisors is launching a fund aimed at attracting retail investors skeptical of the market.
Recent market activity reflects the shifting landscape. Dealers have been accumulating U.S. High-grade corporate notes at the fastest pace in at least a decade, coinciding with a near-record week of issuance. Meanwhile, Goldman Sachs is advising investors to consider high-yield debt from the energy sector, alongside mortgage bonds and credit derivatives, as a hedge against Middle East turmoil and potential inflation.
The Federal Reserve’s recent proposals to relax capital requirements for banks could potentially free up billions of dollars for lending, share buybacks, and dividends, further influencing market dynamics. However, bond traders are currently not pricing in any U.S. Rate cuts this year, a shift influenced by persistent inflation and rising energy costs.