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A bond sector for singles instead of home runs

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Alexander Payne, CFA, Portfolio Manager, Global Income Group, Eaton Vance Management

      Boston - For most fixed-income investors, 2018 can't end soon enough. In an unusual year when most asset classes posted losses and cash outperformed almost everything, even investment-grade bonds offered little or no respite.

      Now, it's the time of year for portfolio reviews and, of course, Wall Street 2019 bond-market outlooks. Strategists will gaze into their crystal balls and confidently predict which fixed-income sectors will perform best next year. This is not one of those outlooks.

      One thing does seem certain: The range of outcomes for 2019 is as wide as any year in the past decade. Will a trade war and aggressive Federal Reserve rate hikes lead to a slowdown and more volatility? Or will wage growth and tax cuts strengthen the economy and shore up financial markets?

      In this uncertain environment, we think it makes sense to aim for singles, rather than home runs. In other words, the idea is to look for slow and steady, rather than swinging for the fences and chasing Wall Street's top-sector predictions.

      With that in mind, one area investors may be overlooking are agency mortgage-backed securities (MBS). This is understandable due to concerns the housing market may be slowing, combined with the recent widening of credit spreads in some areas of the fixed-income markets.

      What are agency MBS?

      Many people correctly identify mortgages as one of the root causes of the 2008 financial crisis, but incorrectly lump together government agency MBS with non-agency MBS, sometimes called subprime.

      Simply put, agency MBS are fully guaranteed by U.S. government agencies such as Ginnie Mae, Fannie Mae and Freddie Mac (the agencies bundle mortgages together into securities that are investable). On the other hand, non-agency MBS are backed only by the creditworthiness of the homeowner.

      Despite their negative connotation from the crisis, we believe agency MBS can play a supporting role in fixed-income portfolios. Specifically, they may offer slightly more income than Treasurys, but with similar profile of credit quality and lower duration.

      MBS may offer these advantages:

      • Higher yields than Treasurys: At the end of November, the Bloomberg Barclays US MBS Index had a yield to worst of 3.65%, compared with 2.93% for the Bloomberg Barclays US Treasury Index.
      • Lower duration than Treasury bonds: Agency MBS may also be less sensitive to interest rates because they often have lower durations than some other investment-grade bonds such as Treasurys and corporate bonds.
      • Diversification: Agency MBS have historically low correlations with equities and other fixed-income asset classes, which may help to diversify broad portfolios.
      • Liquidity: The U.S. agency MBS market is one of the most liquid of the world due to its huge size. Outstanding securities in the agency MBS market totaled nearly $7.2 trillion as of December 2018, according to the Securities Industry and Financial Markets Association (SIFMA).

      Hitting singles

      To be clear, agency MBS will likely not be the best performer in 2019 -- that title is usually reserved for either the riskiest or safest asset. Yet, we believe combination of a U.S. government guarantee and lower duration than Treasurys make the sector resilient to spillover from volatile credit and interest rate markets.

      And for investors who may be hesitant to invest in mortgages because of memories of the credit crisis, it might make sense to take a look at how agency MBS performed during that time.

      Blog Image MBS Performance Annual Dec 13

      The Bloomberg Barclays US MBS Index gained 8.34% in 2008 amid the "flight to quality," which included agency-backed mortgages. Although the MBS index is on track for a slight loss in 2018, it would only be the second calendar-year loss since 2008 (the index lost 1.4% in 2013). For this year (2018), we would note that some subsectors of the MBS market are positive such as floating-rate agency MBS.

      That historical consistency -- combined with other benefits such as similar credit quality, low duration and relatively attractive yield -- may make agency MBS a candidate for a supporting role in fixed-income portfolios.

      Bottom line: From our perspective, for investors looking to hit singles rather than home runs in bond portfolios, agency MBS may be worth considering.