The agency MBS sector turned in a resilient performance in December, consistent with the broader risk-on tone across markets. As the first COVID-19 vaccines began to be administered in the U.S. and around the world, risk assets largely shrugged off news of additional lockdowns in several major cities and the S&P 500 recorded a monthly gain of 3.71%, propelling this year’s total returns to 18.39%. This exuberance in the equity markets was matched by a similar enthusiasm in IG Corporates, which posted 0.79% excess returns this month over U.S. Treasuries, bringing excess returns this year to 0.49%. In the face of strong returns in these “higher beta” asset classes, agency MBS returns were, by contrast, relatively subdued, with excess returns of 0.22% in December, closing out the year with excess returns of -0.17% and total returns of 3.87%.

December added to the familiar narrative of production coupons outperforming higher coupons since the Fed began agency MBS purchases in March. UMBS 2.0 added 21 basis points (bps) of excess returns in December while UMBS 2.5 contributed 63 bps. This capped off a year of low coupon outperformance versus higher coupons in the MBS Index, with UMBS 2.0s and 2.5s delivering 2.74% and 1.57% excess returns respectively, compared to -0.92% for UMBS 3.0s and -0.80% for UMBS 3.5s. Although production coupon TBA rolls continued to trade special, further adding to the returns of lower coupons, dollar rolls have come off slightly from the persistently high levels observed in previous months.

Agency MBS valuations in 2020 could aptly be characterized as a tale of two forces: fundamentals shaky, technicals strong. As mortgage rates continue to notch record low after record low, with the most recent Freddie Mac 30-year fixed survey rate at 2.67%, specified pool payups on even marginal call-protection stories have reached historically high levels. However, in the face of record low mortgage rates and an ever-shrinking primary-secondary spread, specified pools have struggled to find their footing as prepayment speeds on loan balance stories are plateauing at sharply higher speeds. These dynamics have continued to weigh on valuations of higher coupon agency MBS and, thus far, have given no indication in subsiding. Specifically in the Ginnie Mae space, the lower credit quality of Ginnie borrowers has resulted in forbearance at almost twice the rate of conventional borrowers. Because Ginnie Mae servicers control the buyout process, Ginnie Mae pools initially saw eye-watering prepayment speeds as bank servicers, with access to cheap funding in an era of low rates, began to buy out eligible loans immediately en masse. Although this initial buyout wave has abated somewhat, Ginnie Mae pools, particularly in higher coupons, are still prepaying at markedly faster speeds than conventional pools.

Households in Ginnie Mae MBS Are Twice as Likely To Be in Forbearance

Source: Mortgage Bankers Association, Bloomberg, Nomura

These headwinds in mortgage fundamentals were buffered by favorable technicals courtesy of persistent Fed support. Relentless Fed buying has resulted in agency MBS spreads swiftly rallying back to historically tight levels. Fed buying has further cleaned up the deliverable float in production coupons, as they continue to take down the worst-to-deliver pools, and contributed to TBA roll specialness. While TBA roll specialness has accompanied every Fed QE period, 2020’s dollar rolls stand out for their persistently high levels, averaging almost 2.5 ticks of specialness since March. With agency MBS spreads and specified pool payups at historically rich levels, the fundamental spread and yield performance that could be gained from security selection has paled in comparison to the excess carry that could be earned in the TBA market. Indeed, we expect these technical dynamics to continue to dominate the conversation in agency MBS valuations for 2021.

Roll Specialness Was Persistently High in 2020

Source: JP Morgan