Demand for corporate bonds might receive an unexpected boost in the coming months. This surge could come from investors who are cashing in profits on their US mortgage bond holdings. These investors now need to find another asset to purchase with their freed-up capital.
Mortgage Bonds See Strong Gains
Mortgage-backed securities have delivered impressive returns this year. Through Thursday, they gained 0.45%, outperforming most other debt instruments. This rally followed a statement from US President Donald Trump. He demanded that Fannie Mae and Freddie Mac purchase an additional $200 billion of these bonds.
Risk premiums on newly issued MBS have tightened significantly. They narrowed by about 0.15 percentage points, reaching their lowest level since 2022. This performance builds on an already stellar year for mortgage bonds in 2025. Total returns hit 8.6%, marking the highest figure since 2002.
Analysts Predict a Shift
Money managers and Wall Street strategists are now questioning whether this trend will reverse. Hans Mikkelsen, a credit strategist at TD Securities Inc., shared his insights in a January 13 note. He wrote, "We think these tight valuations in MBS will prompt a sizable rotation out of MBS and into competing products — obviously Treasuries given the lack of spread, but also back into corporate bonds."
However, any major shift is still in its early stages. For most of last year, money managers were moving in the opposite direction. They viewed MBS as a safe haven from the high valuations in corporate bonds. Large firms like Vanguard Capital Management LLC and TCW Group Inc. have expressed continued preference for mortgage bonds. This is because spreads on corporate notes globally have tightened to levels not seen since 2007.
Peter Van Gelderen, TCW's co-head of global securitized products, noted that the yield premium for corporate credit risk remains extremely narrow. It is even inverted when compared to agency MBS.
Valuations and Opportunities
Brian Quigley, head of MBS and senior portfolio manager at Vanguard, offered a nuanced perspective. He pointed out that while valuations in the most liquid parts of the MBS market are tight, sophisticated active managers can still find value. Some of the more esoteric market segments continue to present attractive opportunities.
This year is also expected to witness record sales of high-grade US corporate bonds. Part of this issuance will help fund infrastructure projects related to artificial intelligence.
The Changing Landscape
The comparative value between assets appears to be shifting after the recent mortgage bond rally. Spreads on recently issued MBS are now much closer to risk premiums on higher-quality, intermediate-duration corporate bonds. Data compiled by Bloomberg shows the gap between these two sets of spreads has reached its lowest point in about four years.
Maulik Bhansali, senior portfolio manager at Allspring, commented on this development. He said, "The most recent MBS outperformance on Trump’s directive has reduced the relative attractiveness of the sector." Bhansali has slightly reduced his MBS position but remains overweight.
Morgan Stanley adjusted its stance on mortgage bonds this week. The firm lowered its view from positive to neutral, citing valuation concerns. Strategists Jay Bacow, Zuri Zhao, and Janie Xue outlined both sides in a January 13 note. They acknowledged reasons to still like the securities, including potential increased demand from Fannie Mae and Freddie Mac. Regulatory incentives for banks to buy more bonds could also support the market.
On the flip side, geopolitical concerns or policies that increase the supply of mortgage bonds might pressure returns.
Bullish Signals for Credit
There are reasons to maintain a bullish outlook on credit, even with high valuations. Barclays strategists provided an analysis. They expect corporate issuance to rise this year. However, US Treasury note and bond sales are likely to fall sharply. This could result in total fixed-rate bond sales remaining roughly flat. Consequently, investors might move some funds out of Treasuries and into company debt.
Global economic growth remains robust. The World Bank recently upgraded its growth forecast for this year to 2.6%, up from 2.4%. While this is slightly slower than the estimated 2.7% growth for 2025, it still indicates economic resilience.
Limited Upside for Mortgage Bonds
Marc Bushallow, managing director of fixed income at Manning & Napier Advisors LLC, shared his firm's perspective. With mortgage bonds having gained substantially in recent weeks, he believes the upside potential is now limited. His company has been reducing its exposure to mortgage bonds for several months.
Bushallow stated plainly, "There are other places where you can find better returns now." This sentiment captures the growing investor appetite for alternatives as market dynamics evolve.
