January Agency MBS Update

Monthly Commentary

February 02, 2017

Global markets were nearly unchanged in January from a bird’s eye view, yet agency MBS valuations were pressured by percolating uncertainty and growing investor concern during the first month of 2017. The year opened with tepid price action in global markets, with U.S. Treasury yields ending close to unchanged in January and risk assets closing just above their opening marks. Relative calm usually bodes well for agency MBS valuations, which tend to benefit from unchanged markets, as lower volatility benefits mortgage investors. Rate volatility dropped in January, yet the subdued price action was not enough to help agency MBS post positive excess returns due to policy and macro risk factors that caused investors to shy away from the asset class. The macro risk of an increasingly hawkish Federal Reserve as well as the policy risk of a new president and cabinet each present unique challenges to the agency MBS landscape. In concert, the risks weighed down agency mortgage valuations despite a seemingly calm market landscape. The result was the Barclays MBS Index underperforming benchmark Treasuries in January, leaving excess returns at negative 24 basis points.

From a macro perspective, the key risk factor affecting agency MBS valuations is a Federal Reserve that increasingly looks to be winding down the extraordinary monetary measures used during the financial crisis. Specifically, there is increasing noise around the idea of reducing the FOMC’s portfolio of agency MBS securities in the relatively near future. The current policy has the Fed buying agency MBS as they receive pay downs from their current market holdings of $1.7 trillion, leaving their overall holdings unchanged. If the Fed were to taper reinvestments over time, their agency MBS holdings would slowly run off their balance sheet. This process is due to commence when the Federal Funds rate hits 1% or shortly thereafter. One of the prevailing sentiments among FOMC members has been an increasing belief that an uptick in inflation and the possibility of stronger U.S. growth could require the Fed to increase the pace at which they hike the Federal Funds rate. Notably, Chairwoman Janet Yellen remarked on January 18th that she could see the Fed potentially hiking interest rates three times in 2017. A fast pace of interest rate hikes means that, depending on market conditions, tapering could begin as soon as late this year. This development has investors concerned about how the agency MBS sector will look without active Federal Reserve participation. Given that the Fed currently holds securities totaling just shy of 30% of the agency MBS universe, any attempt to reduce FOMC holdings will be a fundamental paradigm shift for mortgages, one that could have negative consequences for valuations going forward.

The regulatory landscape provided the second area of concern for agency MBS investors in January. The introduction of a new President invariably changes the regulatory picture somewhat no matter the circumstances; however the inauguration of Donald Trump marks not only a shift in power from one political party to another, but also is the first change in leadership since many of the post-crisis regulations and policies were established. The changes were evident in January, when in the closing days of the Obama Administration the Federal Housing Administration announced a 25 basis point (bp) cut in the monthly insurance premium (MIP) that borrowers pay to help guarantee their mortgages. This cut negatively impacted Ginnie Mae valuations, as investors became worried that prepayment speeds would pick up across the Ginnie Mae coupon stack. However, the MIP change was promptly suspended indefinitely by the new administration. While one reversed ruling does not mean that the current regulatory framework for agency MBS will be overhauled by new appointees and policies, each regulatory issue that the administration deals with will be seen through a very different lens. This change in perspective may lead to different outcomes in future policy deliberations, and could include opportunistically revising regulations and policies that the current administration would like changed. Ultimately, both the FOMC and the new administration could have an outsized impact on agency MBS valuations in 2017 and beyond.

Performance within the coupon stack bore the brunt of the macro overhang seen in January. Most notably, higher coupons outperformed their lower coupon counterparts despite unchanged mortgage and U.S. Treasury rates in January. Fannie Mae (FNCL) 3.5s came in at -28bps relative to their U.S. Treasury hedge ratios (HRs), while FNCL 4.5s finished at -6bps vs. HRs. Market participants appear to be concerned that extension risk from higher rates or a less active Fed will curtail valuations in lower coupon mortgages. This worry has pushed investors into shorter duration assets including high coupon 30yr and 15yr mortgages. In the 15yr space, FNCI 3s came in at just -3bps, outpacing 30yr counterparts. Somewhat predictably, the worst performing sector was Ginnie Mae 30yr (G2SF) collateral. G2SF 3s came in -37bps relative to benchmark Treasuries, while G2SF 4s struggled to the tune of a -41bps. Ginnie Mae collateral usually outperforms when investors seek protection from higher interest rates, however the month long drama over the fate of the MIP acted as a drag on valuations. The cut was suspended indefinitely; however, the unpredictability of regulatory policy has a negative impact for that portion of the agency MBS market. In the coming month, the coupon stack will see the effects of an expected steep decline in prepayments, as well as the continuing macro and policy overhang in the agency MBS sector.

Prepayment speeds in the December report continued to decline. Speeds fell 11% overall in December, and there were some surprising elements. Most notably, lower coupons saw speeds decline significantly, while higher coupons had faster than anticipated prepayments. Specifically, FNCL 3 speeds were down 20%, while FNCL 4.5 speeds were almost unchanged at 23.8CPR. The surprising prepayment data ran in contrast to the relative outperformance of higher coupon MBS in January. Further up the coupon stack, many premium coupons actually saw speeds increase, which was a surprising deviation from expectations. It will be important to monitor the steepening prepayment curve seen in this report to see if current trends prevail in the upcoming report that is sure to be a high priority for market participants. The full weight of the slowdown in prepayments is set to hit, giving investors their first look at much slower speeds expected over the next several months. The magnitude of the slowdown will provide the market with increased clarity as the calendar flips to the second month of the year.


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