Featured Insight

Notes from the Agency MBS Desk: Buy Low, Sell High (Coupons)

Published:

As a follow up to our recent piece: “Refi-Nation: Agency MBS Investing in a New Paradigm,” we further examine opportunities in the agency MBS market today.

In stark contrast to last year’s “lower for longer” rate environment, 2021 thus far has been marked by an abrupt selloff in Treasuries and a steepened yield curve. While the debate rages on whether rates have risen for the “right” reasons, agency MBS investors are left to grapple with the very tangible reality that mortgage rates have climbed sharply. In just three months, the Freddie Mac 30-year fixed survey rate has since come off its low of 2.65% in December, reaching 3.09% this week. With the upswing in mortgage rates and extension in agency MBS duration buoying returns in higher coupon relative to lower coupon agency MBS, is it time for agency MBS investors to leave the shallow waters safeguarded by the Fed and set sail into treacherous “up-in-coupon” seas?

The strength in lower coupon agency MBS that had so characterized 2020 had been turned on its head in the recent months, as higher coupon agency MBS excess returns continued to outperform their lower coupon counterparts. Extension risk is now front and center for agency MBS investors, as lower coupon agency MBS, with longer duration and added negative convexity, underperformed due to the forceful sell off in long-end Treasuries. Year to date, conventional 2.0s and 2.5s posted -75 basis points (bps) and -106 bps of excess returns to U.S. Treasuries respectively, compared to +63 bps in conventional 3.0s and +109 bps in 3.5s. This impetuous interest in higher coupon agency MBS was tempted by prospects of rising mortgage rates slowing prepayments as “burnout” is realized in seasoned pools. However, a number of factors we have observed have shown that such expectations are unfounded, as the mortgage market evolves and participants change behavior.

Historically, seasoned pools exhibit “burnout” as the remaining borrowers are “negatively selected” to have weak responses to refinance incentive – once a source of strong call protection for agency MBS investors. However, performance observed throughout this COVID-19 driven refinance wave has demonstrated that the burnout effect in seasoned pools has remained elusive. Indeed, seasoned loans today have repaid at markedly faster speeds compared to seasoned loans at similar incentive levels since 2015.

50-70 WALA TBA Loans Incentive Versus CPR
Jan. 2015 - Present

Source: Bloomberg, TCW

Observing changes in S-Curve performance throughout the COVID-19 crisis reveals that call protection in seasoned loans steadily deteriorated as the refinance wave wore on.

Call Protection From “Burnout” Has Weakened Through the COVID-19 Crisis

Source: Bloomberg, TCW

The recent higher rate environment has, so far, produced only a meager effect on the demand for and pace of refinancing. The primary-secondary spread has continued to compress since the peak of COVID-19 capacity constraints, suggesting ongoing efficiency in mortgage origination.

Primary-Secondary Spread
Jan. 2018 - Present

Source: Bloomberg, TCW

The MBA Refi Index remains at elevated levels, as approximately 65% of the mortgage market remains economically incentivized to refinance at a 3% mortgage rate, pointing to continued demand. In these conditions, we expect elevated prepayments to persist well into 2021, a risk most heavily borne by higher coupon agency MBS.

MBA Refi Index Versus 30 Yr Mortgage Rate
Jan. 2018 - Present

Source: Bloomberg, TCW

Although the recent rise in mortgage rates may have given pause to the relentless widening in performance between lower and higher coupon agency MBS since the onset of QE4, the new paradigm of “Refi-Nation” is still very much in place. Mortgage originators relentlessly push the boundaries of underwriting efficiency and the Fed graciously supports the agency MBS market with generous purchases of production coupons. In this environment, we continue to see value in the carry and technical strength in the return profile of lower coupon agency MBS relative to the more persistent risks in higher coupons.

Carry in Lower Coupon TBAs Continue to Outstrip Carry in Higher Coupon TBAs

Source: TCW, JP Morgan

Disclosure

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2024 TCW