Agency basis

What Is Agency Basis?

Agency basis refers to the spread between the yield of an agency mortgage-backed security (MBS) and the yield of a U.S. Treasury security with comparable duration. It is a key metric within fixed income markets, specifically for investors and traders involved with mortgage-backed securities (MBS). Agency MBS are debt instruments backed by pools of mortgage loans and guaranteed by U.S. government-sponsored enterprises (GSEs) such as Fannie Mae or Freddie Mac. The agency basis reflects the additional yield investors demand for holding agency MBS compared to the perceived risk-free return of Treasury securities.

History and Origin

The concept of agency basis gained prominence as the market for mortgage-backed securities grew, particularly with the increased activity of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac in securitizing mortgages. These entities were created to provide liquidity to the housing finance system, and their role expanded significantly over decades. Agency MBS became a cornerstone of the U.S. housing market, providing a mechanism for lenders to sell mortgages and replenish capital for new loans.⁹

A pivotal moment for the agency basis and the MBS market at large occurred during the 2008 financial crisis. As the housing market deteriorated and concerns mounted about the financial health of Fannie Mae and Freddie Mac, the U.S. government took them into conservatorship in September 2008. This unprecedented intervention aimed to stabilize the housing finance system and prevent a broader economic collapse.⁸ The Federal Reserve also played a crucial role in supporting the agency MBS market through its "large-scale asset purchases" program, often referred to as quantitative easing, where it bought substantial quantities of agency MBS to lower long-term interest rates and provide market liquidity.⁷,⁶ These actions significantly impacted the agency basis by influencing the demand and yield of agency MBS relative to Treasuries.

Key Takeaways

• Agency basis is the yield spread between an agency mortgage-backed security and a U.S. Treasury security of similar duration.
• It measures the additional compensation investors require for holding agency MBS over U.S. Treasuries.
• Factors like prepayment risk, supply and demand dynamics, and market liquidity influence the agency basis.
• A widening agency basis suggests agency MBS are becoming cheaper relative to Treasuries, while a narrowing basis implies they are becoming more expensive.
• The agency basis is a critical indicator for investors engaged in basis trading and hedging strategies.

Formula and Calculation

The calculation of agency basis is straightforward: it is the difference between the yield of an agency MBS and the yield of a comparable Treasury security.

$\text{Agency Basis} = \text{Yield}_{\text{Agency MBS}} - \text{Yield}_{\text{Treasury Security}}$

Where:

• (\text{Yield}_{\text{Agency MBS}}) is the yield to maturity (or a comparable yield measure, such as option-adjusted spread) of the agency mortgage-backed security.
• (\text{Yield}_{\text{Treasury Security}}) is the yield to maturity of a U.S. Treasury security with a similar duration or maturity profile.

This difference is typically expressed in basis points.

Interpreting the Agency Basis

Interpreting the agency basis involves understanding market sentiment and the relative attractiveness of agency MBS compared to risk-free government debt. A positive agency basis indicates that agency MBS offer a higher yield than comparable Treasuries, compensating investors for additional risks such as prepayment risk and lower liquidity.

When the agency basis widens, it suggests that investors are demanding more compensation for holding agency MBS, potentially due to increased uncertainty in the housing market, reduced demand from large institutional buyers (like the Federal Reserve reducing its balance sheet), or concerns about the GSEs. Conversely, a narrowing agency basis implies that agency MBS are becoming more appealing relative to Treasuries, perhaps driven by strong housing market performance, robust demand, or perceptions of reduced risk. Traders and portfolio managers constantly monitor this spread to identify opportunities or manage portfolio risk.

Hypothetical Example

Suppose an investor is evaluating an agency MBS with a 10-year average life. They find that this MBS has a yield of 4.50%. Simultaneously, a 10-year U.S. Treasury note, which serves as a benchmark for risk-free assets, is yielding 4.00%.

To calculate the agency basis:

$\text{Agency Basis} = \text{Yield}_{\text{Agency MBS}} - \text{Yield}_{\text{Treasury Security}}$
$\text{Agency Basis} = 4.50\% - 4.00\%$
$\text{Agency Basis} = 0.50\% \text{ or } 50 \text{ basis points}$

In this scenario, the agency basis is 50 basis points. This means that the agency MBS offers an additional 0.50% yield over the comparable Treasury security. This extra yield compensates the investor for risks specific to MBS, such as the uncertainty of future cash flows due to mortgage prepayments or extension risk, and the fact that agency MBS, while implicitly government-backed, are not direct obligations of the U.S. Treasury.

Practical Applications

The agency basis has several practical applications across financial markets:

• Relative Value Trading: Traders use changes in the agency basis to identify relative value opportunities. If the basis widens significantly, agency MBS may be considered "cheap" relative to Treasuries, prompting buying activity. Conversely, a very narrow basis might suggest agency MBS are "expensive," leading to selling or shorting. This type of arbitrage strategy relies on the expectation that the spread will eventually revert to its historical average or a fair value.
• Risk Management: Portfolio managers holding large amounts of agency MBS use the basis to gauge and manage their exposure to interest rate risk and spread risk. Fluctuations in the agency basis can impact the overall performance of a bond portfolio.
• Federal Reserve Policy Analysis: The Federal Reserve's actions, particularly during periods of quantitative easing or tightening, directly influence the agency basis. For example, during the 2008 financial crisis and subsequent recovery, the Federal Reserve purchased vast quantities of agency MBS to support the mortgage market and lower long-term interest rates.⁵,⁴ These purchases significantly compressed the agency basis by increasing demand for agency MBS. Understanding the Fed's stance on its balance sheet can provide insights into potential future movements in the basis.
• Repo Market Dynamics: The agency basis also plays a role in the repo market, where financial institutions lend and borrow against securities. Agency MBS are frequently used as collateral, and their value relative to Treasuries, as indicated by the agency basis, can influence funding costs and market activity.

Limitations and Criticisms

While the agency basis is a widely used metric, it has limitations. One primary criticism stems from the inherent complexity of valuing mortgage-backed securities, which are subject to factors like prepayment risk (the risk that homeowners refinance or pay off their mortgages early) and extension risk (the risk that mortgages are paid off later than expected). Unlike fixed-maturity Treasury bonds, the effective duration and cash flows of MBS are uncertain and depend on borrower behavior, interest rate movements, and economic conditions. This makes a precise "comparable duration" Treasury security difficult to identify, potentially complicating the interpretation of the agency basis.³

Furthermore, the liquidity of the agency MBS market, while generally high, can vary. During periods of financial stress, liquidity can diminish, leading to a wider agency basis as investors demand a higher premium for the perceived difficulty in selling these securities quickly. This widening might not solely reflect fundamental credit risk but also a liquidity premium. The reliance on models to estimate MBS valuations and risks means that the agency basis can also be affected by model limitations or changes in model assumptions, leading to potential misinterpretations or unexpected movements.

Agency Basis vs. Treasury Basis

While "agency basis" specifically refers to the spread between agency MBS and U.S. Treasuries, the broader term "Treasury basis" or simply "basis" can refer to the spread between any financial instrument and a U.S. Treasury security. The key distinction lies in the underlying instrument being compared to the Treasury.

Confusion can arise because both involve comparing a security's yield to that of a Treasury. However, the unique characteristics and risks of agency MBS, particularly their exposure to prepayment and extension risk, make the agency basis a specialized form of spread analysis within the broader fixed-income landscape.

FAQs

What causes the agency basis to change?

The agency basis changes due to shifts in the supply and demand for agency MBS, changes in perceived risks (like prepayment risk or credit risk), overall market liquidity, and broader economic conditions. For instance, if the housing market is booming and mortgage rates are falling, prepayment risk for existing MBS may increase, leading investors to demand a higher yield, thus widening the basis. Conversely, strong demand from large buyers can narrow it.

Is a wider or narrower agency basis better?

Neither a wider nor a narrower agency basis is inherently "better"; it depends on an investor's strategy and perspective. A wider agency basis means agency MBS offer a higher yield premium over Treasuries, potentially making them more attractive to investors seeking yield. For those looking to buy, a wider basis might signal a buying opportunity. A narrower basis, conversely, means agency MBS are yielding less relative to Treasuries, which might be a good sign for existing holders as their value has increased. Traders exploit movements in both directions.

How does the Federal Reserve influence the agency basis?

The Federal Reserve significantly influences the agency basis through its monetary policy actions, particularly during periods of quantitative easing (QE) or quantitative tightening (QT). During QE, the Fed purchases large volumes of agency MBS, increasing demand and often narrowing the agency basis by driving up MBS prices and lowering their yields relative to Treasuries. During QT, when the Fed reduces its MBS holdings, it can lead to a widening of the basis.²

Are agency MBS considered risk-free like U.S. Treasuries?

No, while agency MBS are guaranteed as to timely payment of principal and interest by U.S. government-sponsored enterprises like Fannie Mae or Freddie Mac, they are not direct obligations of the U.S. government itself.¹ This means they carry a very low credit risk, similar to Treasuries, but they are still subject to other risks, most notably prepayment risk, which Treasuries do not have. This distinction is a primary reason why agency MBS typically trade at a positive agency basis.