MBS and Active Carry: Unlocking High-Yield Opportunities in a Low-Rate World

In an era defined by historically low interest rates and persistent equity market volatility, institutional investors are increasingly turning to agency mortgage-backed securities (MBS) as a cornerstone of high-yield, risk-managed portfolios. The interplay between agency MBS and active carry strategies has emerged as a compelling framework for capitalizing on structural advantages in the fixed-income market, particularly in environments where traditional yield sources have diminished. This analysis explores how strategic portfolio positioning using agency MBS, combined with active carry tactics, can unlock alpha while mitigating downside risks.

Agency MBS: A Resilient Foundation for High-Yield Portfolios

Agency MBS, backed by government-sponsored enterprises like Fannie Mae and Freddie Mac, have demonstrated remarkable resilience in low-rate environments. According to the Janus Henderson report, the Bloomberg U.S. MBS Index recorded a 3.35% year-to-date return in 2025, marking one of its strongest starts since 2020 (Janus Henderson report). That analysis also notes that over 70% of U.S. mortgages originated during the 2020–2021 low-rate period now sit at rates below 5%, far below the current 6%+ mortgage rate landscape. The resulting stability in cash flows and reduced negative convexity has made agency MBS a defensive asset class, outperforming investment-grade corporates during equity market corrections, Michael Benedict observes (Michael Benedict).

Moreover, the structural shift in MBS issuance-toward higher coupon rates (e.g., 5.5%+ 30-year bonds)-has enhanced their insulation against price declines in rising rate scenarios, Morgan Stanley notes (Morgan Stanley). For instance, the SanCap guide highlights that higher coupon segments of the MBS market exhibit greater sensitivity to front-end yield curve movements, offering asymmetric returns during periods of curve steepening (SanCap guide). This dynamic positions agency MBS as a versatile tool for yield generation, even in a low-rate world.

Active Carry Strategies: Leveraging MBS for Enhanced Returns

Active carry strategies in agency MBS involve exploiting yield differentials, duration mismatches, and prepayment dynamics to generate risk-adjusted returns. A key tactic is yield curve positioning, where investors allocate to higher coupon bonds (e.g., Fannie Mae 6.5% bonds) to capitalize on their sensitivity to short-term rate changes; the SanCap guide provides a useful framework for these allocations. These bonds benefit from falling two- and five-year rates, which are often linked to Federal Reserve easing cycles. Conversely, lower coupon bonds (e.g., 2.0% coupons) are more exposed to 10-year rate movements, making them suitable for flattening curve scenarios.

Duration management further refines these strategies. By using collateralized mortgage obligations (CMOs), investors can shorten the cash flow profile of 30-year MBS while maintaining attractive relative value, as discussed by Morgan Stanley. For example, Michael Benedict highlights how CMO tranches allow portfolio managers to isolate specific duration buckets, reducing exposure to long-term rate volatility while retaining yield. This approach is particularly effective in a low-prepayment environment, where refinancing activity remains subdued due to elevated mortgage rates.

Leverage and Hedging: Balancing Risk and Reward

Leverage amplifies the potential of active carry strategies in agency MBS, though it requires disciplined risk management. A typical leveraged trade involves financing a $100 million MBS position with $12.5 million of equity and repo financing, yielding returns tied to the spread between the MBS yield and the repo rate, according to a Federal Reserve note (Federal Reserve note). However, this strategy is vulnerable to basis risk and yield curve inversion. To mitigate these risks, hedged carry strategies employ Treasury futures or SOFR swaps to neutralize duration exposure. For instance, a 30-year 5.5% pass-through position hedged with 2- and 10-year swaps can generate a consistent 14.73% return on equity (ROE), independent of repo rate fluctuations, according to the same Federal Reserve analysis.

Option-adjusted carry strategies add another layer of sophistication. By incorporating delta-hedging or options to manage prepayment risk, investors can refine their ROE projections. The Federal Reserve note also cites Bloomberg models estimating that a 30-year 5.5% pass-through has an option-adjusted spread (OAS) of 62 basis points, translating to a projected ROE of 10.09% after hedging costs. This underscores the importance of granular analysis in identifying pockets of value within the MBS market.

Strategic Implications for Portfolio Managers

The integration of agency MBS and active carry strategies offers a robust framework for portfolio positioning in low-rate environments. Key takeaways include:
1. Yield Curve Arbitrage: Prioritize higher coupon bonds in steepening scenarios and lower coupon bonds in flattening environments.
2. Duration Flexibility: Use CMOs to tailor duration exposure and reduce long-term rate risk.
3. Leverage Discipline: Employ hedging to isolate MBS-specific risks and stabilize ROE.
4. Relative Value Focus: Target agency MBS with spreads above historical averages, particularly against investment-grade corporates, as discussed by Morgan Stanley.

As the Federal Reserve signals potential rate cuts and quantitative tightening unwinds, the relative value of agency MBS is expected to improve further, a point Michael Benedict emphasizes. Investors who combine structural advantages-such as government guarantees and low credit risk-with tactical active management will be well-positioned to capitalize on this evolving landscape.