Banks snatch up mortgage bonds that saw best returns since 2002

By Ameya Karve | Bloomberg

Flush with deposits, US banks are buying up mortgage bonds and betting that the asset class will get a further boost in 2026 from relaxed capital rules.

Late last year, commercial bank holdings of mortgage paper reached the highest level since 2023, and stood at more than $2.7 trillion toward the end of December, according to Federal Reserve data that wasn’t seasonally adjusted. That sum has increased for four consecutive months through November, the longest such streak since the end of 2024.

As the Fed cuts rates, companies and consumers have less to lose by putting money in low-yielding or zero-interest bank accounts, pushing deposit levels to record highs. Total bank deposits stood at over $18.8 trillion as of Dec. 24, the highest ever, according to the latest released data from the Fed.

Armed with plenty of deposits to invest, banks have piled into the notes as the Fed lowered interest rates and mortgage-backed securities offered more value than corporate debt. Total returns on the notes were 8.6% in 2025, the best annual performance in 23 years, Bloomberg-compiled data show.

Both the gains and purchases from banks are likely to continue this year, said Dan Hyman, head of agency mortgage-backed securities at Pacific Investment Management Co.

“A combination of increasing deposits, attractive spreads, yield curves steepening and the Fed lowering interest rates should increase demand from banks,” he said. Pimco expects “spreads to continue to narrow, as their current valuations remain historically cheap.”

Another tailwind is regulatory: Banks are expecting the Fed to introduce rules that would dramatically relax a Biden-era capital proposal for Wall Street’s largest lenders and revise stress test requirements for mortgage notes.

“Deregulation of rules related to treatment of this asset class and lower uncertainty over interest rates will be the key factors for banks to be active buyers,” said Paul Yang, portfolio manager at Seelaus Asset Management.

Estimates for the amount of mortgage bonds banks will purchase on a net basis next year range from as low as $25 billion from Bank of America Corp. to as high as $105 billion from Robert W. Baird & Co.

And banks aren’t the only firms buying more. Real estate investment trusts have also been adding the securities, as well as Fannie Mae and Freddie Mac.

Each group is stepping up purchases as the Fed — among the biggest holders of MBS — continues to allow about $15 billion of that debt to run off its balance sheet every month. Fed holdings have declined about $697 billion since March 2022 to just over $2 trillion as of last week.

Demand is rampant partly because mortgage bonds appear cheap relative to investment-grade corporate bonds. One indicator is the difference between spreads on high-grade bonds and mortgage securities: that’s around 55 basis points currently compared with a 10-year average of 78 basis points, according to Bloomberg index data.

Morgan Stanley also sees mortgage bonds as cheaper than investment-grade credit. They “sit in the 20th percentile of their 20-year range and have spent 20% of days tighter than current levels,” strategists Jay Bacow and James Egan wrote in a note in November. That’s compared with high-grade corporate bonds, “which are in the third percentile and have spent only 6% of days tighter,” they wrote. Bacow and Egan expect MBS to outperform high-grade credit in 2026.

While demand for mortgage bonds is seen increasing this year, net supply may be relatively light in 2026, possibly leading to further tightening of spreads. The Fannie Mae 30-year current-coupon spread to the 5/10-year Treasury blend narrowed almost 26 basis points in 2025 to just more than 109 basis points, according to data compiled by Bloomberg. That suggests investors became less concerned about risks tied to MBS.

Andrew Szczurowski, co-head of securitized products at Morgan Stanley Investment Management Inc., sees between $200 billion and $300 billion of net supply this year, similar to the level seen in 2025, as the “housing market remains sluggish.”

He expects “spreads tightening a further 15 to 20 basis points from here as bank demand will come on top of other tailwinds that are forming for this asset class.”