Mortgage-Backed Securities in a Rising Rate Environment: A Neglected Fixed-Income Asset Reclaims Value

The U.S. mortgage-backed securities (MBS) market, long overshadowed by its struggles in the high-rate environment of 2023–2025, is showing early signs of re-emergence as a compelling value asset. After years of underperformance driven by aggressive Federal Reserve rate hikes and heightened volatility, Agency MBS spreads have tightened to levels that suggest renewed investor interest-and potentially strong future returns if macroeconomic conditions stabilize.

A Rocky Road: MBS in the 2023–2025 Rate Hike Cycle

From 2023 to mid-2025, Agency MBS faced a perfect storm of challenges. The Fed's aggressive rate-hiking cycle, which pushed the federal funds rate to 5.33% in August 2023, caused Agency MBS spreads to widen to historically elevated levels. By December 2024, the asset class had delivered negative excess returns of approximately -140 basis points, as quantitative tightening, reduced bank participation, and low prepayment activity compounded losses, according to a DoubleLine analysis.

However, the tide appears to be turning. As of early 2025, Agency MBS valuations have reached attractive levels, with nominal spreads narrowing to 120 basis points over the 7-year U.S. Treasury by mid-September 2025-still wider than pre-2020 averages but significantly improved from 2024's peaks. This tightening has been driven by declining Treasury rates and reduced interest rate volatility following the Fed's first rate cut in nearly three years in August 2025, according to a Morningstar report.

Historical Context: MBS Through Past Rate Cycles

To assess the current re-emergence of MBS as a value asset, it is instructive to compare its performance to past rate hike cycles. During the 2004–2006 tightening cycle, for example, MBS spreads widened but eventually contracted as the Fed's gradual approach allowed markets to adjust. Similarly, in the 1980s, when the Fed aggressively raised rates to combat inflation, MBS prices fell sharply but rebounded as rates stabilized, according to a Visual Capitalist chart.

What distinguishes the 2023–2025 cycle is the structural resilience of modern MBS. Today's 30-year Agency MBS, with average coupon rates of 5.5%, are better insulated against price declines in a rising rate environment compared to the lower-coupon MBS issued during the pandemic. This structural advantage, combined with historically low prepayment rates (due to high mortgage rates locking homeowners into existing loans), has created a more stable foundation for the asset class, a point emphasized by DoubleLine.

Valuation Attractiveness and Macroeconomic Tailwinds

Current MBS valuations suggest a compelling risk-reward profile. While nominal spreads have tightened, Option-Adjusted Spreads (OAS)-which account for prepayment and volatility risk-are nearing historic lows, hovering close to zero, according to DoubleLine. This discrepancy indicates that the market is pricing in limited downside risk, potentially leaving room for upside if economic conditions align with a "soft landing" scenario.

DoubleLine Capital, a prominent fixed-income manager, has highlighted that Agency MBS could benefit from a steepening yield curve-a likely outcome if the Fed continues its easing cycle in 2025 and 2026. A steeper yield curve would enhance the relative value of longer-duration MBS, which have historically outperformed in such environments. Additionally, early signs of improved investor demand, including increased holdings by banks and overseas investors, suggest a gradual re-rating of the asset class.

Risks and Uncertainties

Despite these positives, risks remain. A resumption of the Fed's rate-hiking cycle in response to persistent inflationary pressures-particularly from tariffs and fiscal policy-could trigger a sell-off in MBS, given their sensitivity to rate volatility, a risk noted by DoubleLine. Moreover, while prepayment risks are currently low, a sharp drop in mortgage rates in 2026 could accelerate refinancing activity, compressing spreads and eroding returns, as noted in the Visual Capitalist chart.

The Path Forward: Strategic Allocation Opportunities

For investors seeking yield in a low-growth environment, Agency MBS offers a unique combination of income and potential capital appreciation. The asset class's current valuation, structural resilience, and alignment with a potential Fed easing cycle position it as a compelling addition to diversified portfolios. However, success will depend on active management to navigate macroeconomic uncertainties and prepayment dynamics.

As the Fed's policy pivot continues, the MBS market may finally shed its "neglected" label and reclaim its place as a cornerstone of fixed-income investing.