February Agency MBS Update

Monthly Commentary

March 06, 2019

The shortest month of the year was a quiet one for agency MBS despite a constant drumbeat of macroeconomic headlines and persistent regulatory cloud cover. After January saw strong relative agency MBS performance behind lower volatility and falling interest rates, the changes in February were far less pronounced. U.S. Treasury yields rose slightly, while mortgage rates continued to fall following their sharp uptick in the fourth quarter of 2018. Trade tensions eased, as the market gauged that the U.S. and China are inching closer to a trade agreement after many months of global consternation. Economic data also came in above expectations, providing a further boost to risk assets throughout the month. Despite this, relative agency MBS relative valuations were held in check. Slight outperformance was tempered because of a multitude of regulatory and technical factors draining what otherwise was a macro environment conducive to positive relative returns. The Federal Reserve all but announced that the balance sheet wind down would be completed late in 2019, introducing complexity into what was something akin to clarity just a few months ago. MBS holdings will still most likely be reduced as they are now, with the Fed now reinvesting all paydowns into government bonds so that it can achieve an all U.S. Treasury portfolio over time. Yet, it is no longer a foregone conclusion that the reduction of agency MBS holdings will be on autopilot. Further complicating the picture are efforts to reform the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, as well as a an endeavor to standardize their offerings into a common mortgage security (UMBS). Together, these initiatives continue to capture the attention of market participants, weighing on performance. Despite the noise, the return of interest rate volatility to secular lows and a rallying risk market were ultimately too strong of a tailwind. Agency MBS outperformed U.S. Treasuries on a relative basis for the second consecutive month in February. The Bloomberg Barclays MBS Index posted positive excess returns of 6 basis points (bps) relative to benchmark U.S. Treasuries, driving year to date excess returns to 39 bps year-to date. Total returns came in at negative 9 bps on the month, sending 2019 total returns to 70 bps.

Agency MBS coupon stack performance was very quiet in February, as stable interest rates and little coupon stack volatility kept relative performance largely in line. Fannie Mae 30yr (FNCL) 3s came in up just 1bp on the month relative to benchmark U.S. Treasuries, while FNCL 3.5s and 4.5s were up 6 bps and 5 bps, respectively. Ever so slightly higher U.S. Treasury rates contributed to the underperformance of 3s, while higher coupons were hit with a somewhat worrisome prepayment report near the beginning of the month. While less than 20% of the agency MBS universe is currently economically re-financeable, there is a very small refinance wave deriving from the fourth quarter uptick in mortgage rates that was quickly reversed. Borrowers who took out higher coupon loans at the end of 2018 refinanced at higher than expected rates, creating the potential for faster than anticipated speeds in higher coupon MBS over the next couple of months. Ginnie Mae (G2SF) collateral did better, with G2SF 3.5s and 4s finishing up 13 bps and 15 bps, respectively. Slightly higher interest rates are generally beneficial to Ginnie Mae collateral; however, in total, Ginnie Mae bonds only outperformed Fannie Mae and not Freddie Mac collateral. One of the key reasons for this is the coming of UMBS in May. Freddie Mac collateral is appreciating relative to Fannie Mae as markets prepare for UMBS, which should force valuations on the two GSE’s collateral to converge. Freddie Mac has historically traded at a discount to Fannie Mae, which is one of the reasons often given for why UMBS is needed in the market. The outperformance of Freddie Mac suggests that market participants are judging that UMBS will not be delayed and is likely to go into effect as scheduled.

The Federal Housing Finance Administration (FHFA), the driver behind the push for the single security, released a final rule at month end on prepayment alignment between pool securities of Fannie Mae and Freddie Mac. The rule is one of the cornerstones to the high wire act of trying to force two competing entities to align their TBA eligible securities such that the securities of each can be delivered into one single TBA. To make two separate entities’ TBA coexist in one market, it is of paramount importance that both GSEs prepayment speeds are in line. While in the last few years of generally below average market volatility prepayments have come in right on top of each other, shocks and periods of high market volatility have presented serious divergence in the past. Therefore, the FHFA endeavored to make a rule to force the two entities to align their prepayment speeds. In December, the FHFA released their initial rule which many market participants found disappointing, as it did not give specifics as to what would be done to correct misalignment in prepayment speeds, nor did it express exactly how it would prevent the two agencies from pursuing their economic best interests at the expense of the TBA market as a whole. The final rule, released in late February, would do a few different things to try and assuage agency MBS investors. The first places a cap on the weighted average coupon spread at 112.5 bps. The WAC spread is important because it is the difference between the overall interest rate the borrower pays and the coupon of the security the loan ultimately ends up in. WAC spreads have been increasing in part due to the two GSEs competing for market share. The goal is to prevent continuously increasing WAC spreads from polluting the TBA deliverable in production coupon MBS, because higher WAC bonds prepay more quickly. Additional components of the rule include new guidelines for what constitutes misalignment in prepayments, and a new definition of what types of pools the misalignment will be applied to. The rule fell short of recommendations made by SIFMA, which will vote in March on delivery guidelines for UMBS TBA. The rule also discusses fines but gives no specifics as to what punishments would be levied if speeds were not aligned. With UMBS forward contracts scheduled to begin trading in less than one month, market participants are firmly focused on the rollout and potential impacts of the shift in what is currently one of the most liquid markets on earth.

UMBS poses many challenges to the mortgage market in terms of unclear trading conventions, underestimated operational and compliance costs, and unknown second order impacts. Yet with the specter of GSE reform looming over the agency MBS market, and the continuing impacts of Federal Reserve balance sheet reduction, there are in fact a multitude of additional regulatory and technical obstacles to outperformance by agency MBS. While nothing concrete, aside from an outline of principles for GSE reform, has been released by the White House since the summer of 2018, the market is still highly attuned to headlines to see whether the effort will be legislative or based around unilateral action by the Trump Administration. The administration signaled in January that a plan could be forthcoming, yet all has been quiet since. Yet any regulatory change could engender a rapid market reaction, requiring constant vigilance to each and every rumor and headline. The continuing reduction in the Fed balance sheet is particularly challenging to agency MBS outperformance as well, because the worst to deliver bonds are no longer ending up in the Federal Reserve portfolio. This has massively depressed TBA roll levels, benefitting specified pools but hindering valuations on production coupon MBS. The flip side to these challenges is volatility sits near secular lows and risk markets are nearing all-time highs once again. However, agency MBS relative valuations are nowhere near their all-time tights and have not rallied as much as one might expect given the underlying fundamentals. This suggests that there may be value to be obtained in spite of headwinds that may persist for part or all of 2019. Patience will be required, and the challenges are omnipresent, however there are no easy paths to value creation in investing. Therefore, it is imperative that investors weigh the potential rewards as well as the risks, when looking at the agency MBS landscape over the coming months.


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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