With significant 'stroke of the pen' risk from political actions, trying to trade short-term headlines is a losing strategy that leads to being whipsawed. A better approach is to assume markets will be roughly flat by year-end, stay invested, and focus on capturing yield and carry.
While AI will increase prepayment risk from efficient servicers, it also presents an opportunity for investors. AI can be used to identify and bundle loans with specific desirable characteristics into new 'specified pools,' allowing for more precise risk targeting and alpha generation in the MBS market.
Unlike institutions that focus on spreads, a large and growing segment of retail investors cares only about absolute yield. This creates a durable source of demand, as these investors tend to buy into weakness when yields rise, preventing the sustained outflows and sharp sell-offs seen in past cycles.
A generation of investors has only known a market where the Federal Reserve intervenes to prevent crises. This creates a deep-seated belief in a 'Fed put' that won't dissipate until the Fed is forced to let a significant event unfold without a bailout, which is unlikely in the near term.
While mortgage-backed securities (MBS) have rallied and are at five-year tights, the trade is not over. Investment-grade corporate bonds are at 20-year tights, making MBS still look cheap on a relative value basis. The strategy now is to tweak the trade rather than abandon it entirely.
Historically, significant capital rotates from money market funds into corporate credit when the yield advantage hits approximately 100 basis points. With Fed rate cuts anticipated, this key threshold is expected to be reached in the second half of the year, potentially unlocking a portion of the $8 trillion in sidelined cash.
The Federal Reserve has more flexibility to cut rates without stoking inflation if it is simultaneously shrinking its balance sheet. The two actions offset each other, meaning the Fed can provide economic stimulus via rate cuts while concurrently tightening through balance sheet reduction.
Despite forecasts of over $2 trillion in corporate bond issuance driven by AI spending, net supply is down 20% year-over-year after accounting for maturities and coupon payments. Record inflows into high-grade funds are effectively absorbing this new debt, keeping the supply/demand dynamic in balance.
Investment grade tech spreads now trade wider than the broad index, a historical anomaly. This, combined with massive, uncertain supply needs for AI buildouts from companies like Google and Amazon, creates too many unknowns. Investors should avoid the sector until there is more clarity on supply and valuations stabilize.