December Agency MBS Update

Monthly Commentary

January 08, 2019

Agency MBS relative valuations closed 2018 on a sour note, as increasing volatility and a growing storm in global risk markets combined to hamper performance. While November had also been rocky for risk assets globally, agency MBS performance held up impressively, closing flat despite market turbulence. The Agency MBS basis was unable to repeat the feat in a challenging December as valuations came under pressure. The S&P 500 dropped over 9% during the month, down more than 16% from the late September peak. The picture has not been prettier globally. While agency MBS are a higher quality asset than most, sharply lower global risk valuations placed tremendous pressure on performance. Further complicating the picture, U.S. interest rates went on a rally of epic proportions. The 10yr U.S. Treasury has gone from yielding 3.24% in November to closing December at 2.68%, the lowest yields at any time since January. The strong interest rate rally holds a few positives for agency MBS investors, but the general increase in interest rate volatility is not beneficial for the basis. The change in market tenor also surprised Federal Reserve officials. Months after announcing that the market was “a long way from neutral,” Federal Reserve Chairman Jerome Powell had to come full circle, declaring during his December press conference that the Fed is now at “the lower end of neutral.” While the Fed followed through on guidance for a December interest rate hike, the abrupt change in tone was caused by global markets that are not cooperating with attempted policy normalization. Furthermore, there is not a singular news story driving the declining risk asset valuations. Weakening economic data, global and trade uncertainties, and the withdrawal of global central bank stimulus are all taking their toll, driving both risk and agency MBS valuations wider. Ultimately, the gathering storm overwhelmed the safe haven aspects of Agency MBS, sending relative valuations skidding to close 2018. The Bloomberg Barclays MBS Index posted excess returns of negative 15 basis points (bps) in December, relative to U.S. Treasuries. That sent year-to-date excess returns to negative 59 bps. The strong interest rate rally buoyed month-to-date returns, which finished at 1.81%, bringing yearly total returns into positive territory at 99 bps.

The story of the agency MBS coupon stack in December is largely one of declining interest rates. Sharply lower mortgage rates sent higher coupons scurrying for the hills, with lower coupons holding in. Fannie Mae 30yr (FNCL) 3s performed best at positive 13 bps for the month. Meanwhile, FNCL 4.5s and 5s got crushed, coming in at -77 bps and -1% relative to benchmark U.S. Treasuries in a brutal December for the collateral. The decline in interest rates has restored lower coupons to their status as production coupons, leaving higher coupon collateral once again facing limited issuance and potentially faster future prepayment speeds. Ginnie Mae collateral, which usually underperforms conventional MBS in interest rate rallies, did so across higher coupons in December. Ginnie Mae 30yr (G2SF) 4.5s and 5s came in at -87 bps and -1.26% respectively, closing a strong year in painful fashion. Higher coupon Ginnie Mae speeds have fallen over the past few months as a result of efforts by Congress and regulators to curb perceived churning activity in Veterans Affairs lending. However, part of the decline in speeds came from higher mortgage interest rates that made it less economically advantageous for borrowers to refinance. Given the propensity for high prepayment speeds, lower interest rates could reverse some of the progress that has been made curbing high coupon G2SF speeds, adversely impacting valuations. Another challenge to overall MBS valuations in December was a further decline in TBA rolls. Higher financing rates and yearend balance sheet constraints placed a further drag on TBA roll levels. The challenging environment for TBAs is causing investors to put more emphasis on specified pools. The trend toward pools has important ramifications going forward as investors will have to be more selective to find valuable investment opportunities in 2019.

The regulatory news of December was punctuated by the nomination of Mark Calabria as the new Director of the Federal Housing Finance Administration (FHFA). A libertarian-leaning economist, Mark Calabria has been a fairly outspoken critic of the conservatorship of Fannie Mae and Freddie Mac, and the role of the government in the housing market as currently constructed. The pick is notable as it signals that the Trump Administration may make moves to shift the status quo that has persisted recently in GSE reform. While most acknowledge some type of reform is needed, little agreement between the political parties has caused reform efforts to stagnate over most of the last decade. Mr. Calabria still needs to be confirmed by the Senate, a process which might not take place until later in the spring. Assuming he is confirmed, it is still not clear just how much the current administration will seek to do by itself in terms of GSE reform. A looming presidential election in 2020 might keep a Calabria-led FHFA from recapitalizing the GSEs and taking them out from under conservatorship, because any actions that could reduce housing availability carry potential political repercussions. However, if the Administration is less politically motivated, the change in FHFA leadership could have a number of market repercussions. In particular, the FHFA could raise guarantee fees, making it harder for consumers to get new loans and restricting lending. While it is hard to know what the extent of the changes will be, the new direction of the FHFA could play an important role in a number of regulatory issues that will impact mortgage markets over the coming years.

The negative month in relative performance for agency MBS, which capped a bleak year, serves as both cautionary tale and important positive beacon for the sector moving forward. Increasing interest rate volatility in the face of rising tension in global risk markets caused agency MBS to struggle relative to U.S. Treasuries in December. Further increases in volatility in risk markets or interest rates would negatively impact relative agency MBS valuations going forward. However, even in a challenging environment for risk markets, with a sharp change in interest rates, excess returns stood at just negative 15 bps for agency MBS. Almost every other sector of fixed income produced negative excess returns of more significance. With global uncertainty flaring up amid the later stages of the credit cycle, the benefits of agency MBS remain readily apparent. The much lower downside risk of agency MBS makes it an important buffer should markets continue to roil in 2019. While further increases in volatility remain a distinct possibility, the rough year in agency MBS means valuations are more attractive than they otherwise would be. While no market is ever safe, the relative risk-reward benefits of agency MBS going into 2019 should aid in keeping valuations afloat in a growing climate of uncertainty across global markets.

 

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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. © 2019 TCW