Spring finally arrived for agency MBS relative performance in April. Persistent
weakness over the opening three months reversed itself as the second quarter
opened. Reduced volatility, a positive month for risk assets, and beneficial regulatory
developments pushed agency MBS toward positive relative performance in April.
Interest rates rose sharply, as inflation data picked up toward the Fed’s long standing
2% inflation target. Late in April the 10yr U.S. Treasury yield jumped over 3%,
marking the first time since 2014 U.S. Treasury rates crossed that threshold. The
30yr mortgage rate also jumped again, closing the month at 4.73%. Risk assets in
the U.S. held in fairly well in spite of the move, further supporting relative agency
MBS valuations. While interest rates backed up markedly across April, rate volatility
actually fell. The move down in volatility erased much of the relatively modest
increases seen since the beginning of the year, boosting the agency MBS basis
performance but leaving investors wondering when long dormant volatility might
once again return. The regulatory picture was generally accretive to mortgages
in April, with positive news coming from Ginnie Mae. The end result was strong
agency MBS performance despite rising rates in April. Ultimately, powerful tailwinds
propelled agency mortgages to reverse nearly half of the negative performance seen
year to date, while total returns continued to disappoint. In aggregate, the Bloomberg
Barclays MBS Index posted positive excess returns of 18 basis points (bps) relative to
U.S. Treasuries in April, bringing year to date excess returns to negative 21 bps. Total
returns of -50 bps for the month added to a rough year, now registering -1.69% in
total returns thus far in 2018.
Coupon stack performance was positive across the agency MBS universe in April.
The rising tide of relative performance lifted all bonds during the month, benefitting
higher coupon MBS in particular. In Fannie Mae 30yr (FNCL) collateral, 4.5s
demonstrated strength, returning 34 bps of relative outperformance in April. FNCL
4s and 3.5s followed with excess returns of 17 and 16 bps respectively. Higher
coupon MBS were buoyed by shorter durations in a rising rate environment.
Furthermore, rising mortgage rates further dampened the
prepayment profile of agency MBS. Strong performance
of higher coupon collateral reversed much of last month’s
relative outperformance of lower coupon FNCL bonds. April
was even stronger for Ginnie Mae collateral. Ginnie Mae
30yr (G2SF) 4.5s outperformed benchmark U.S. Treasuries
by 56 bps, with 4s and 3.5s posting positive excess returns
of 35 bps and 17 bps respectively. Conventional collateral
typically underperforms Ginnie Mae as rates rise, due to
differing borrower profiles. In addition, Ginnie Mae collateral
received a boost from the continuing saga over high coupon
prepayment speeds on Veterans Affairs sponsored loans.
Ginnie Mae continues to work to slow down prepayment
speeds in higher coupon deliverable pools. This boosted
higher coupon G2SF performance for the month. While TBA
rolls largely traded in line with implied carry in April, G2SF 4.5
and 5s rolls traded well above implied value throughout the
month. A lack of supply of worst to deliver bonds caused the
roll to spike, benefitting investors holding G2SF TBA. As the
calendar turns to May, whether higher coupons can continue
their strong year to date relative success will be an important
subplot to monitor, especially if interest rates do not continue
to provide support.
Regulatory news and updates rained down on the market
in April, as two different components of the agency MBS
market structure saw significant changes. The most notable
development was Ginnie Mae suspending two servicers
from their multi pool program. The suspension is part of the
continuing effort to reduce the prepayment speeds of Veteran
Affairs (VA) loans, after allegations that servicers are churning
loans. Ginnie Mae has struggled to reduce the speeds of
higher coupon Ginnie Mae pools, as prepayments remain
elevated. After warning nine servicers that the prepayment
rates of their originated loans are far too fast, Ginnie
Mae suspended both Nations Lending and NewDay from
participating in the G2SF multi program. While the servicers
are still allowed to originate custom pools with guaranteed
principal, they are barred from joining the TBA deliverable
subset of each G2SF coupon until speeds on their originated
loans slow down. While Nations returned to the multi
program right before month end, it is becoming increasingly
clear that Ginnie Mae is serious about taking the steps
necessary to slow down their higher coupon prepayment
speeds. While it is not yet known whether monitoring and
suspending slow servicers will be enough to overcome what
is largely a problem of economic incentives, the punishing of
above-cohort prepayment speeds might be enough to take the
edge off of problematic prepayment prints, further benefitting
higher coupon Ginnie Mae collateral.
A second parcel of regulatory news from April is important to
the broader agency MBS market, although it will probably not
impact investors until 2019. The Federal Housing Finance
Authority (FHFA) announced that they will implement their
long running Single Security initiative on June 3rd of 2019.
The result of a mandate by FHFA, Single Security will make
both Fannie Mae and Freddie Mac TBA deliverable into one
single TBA labeled UMBS. Under the stated auspices of
creating more liquidity in one of the most liquid markets
in all of fixed income, the plan is to have investors convert
their existing Freddie Mac pools into ”mirror” securities
that contain the same underlying collateral as they currently
do. The mirror securities will resemble Fannie Mae pools in
terms of payment delay. Once converted, the pools of either
entity can be delivered into UMBS TBA. Ideally, having more
bonds that are deliverable will make TBA Rolls less likely
to trade special, while eliminating the difference between
Fannie and Gold TBA swaps. The challenge is that real life
is often far from ideal. The lack of differences in Freddie
and Fannie Mae deliverability could discourage both entities
from innovating, as neither will have much of an incentive to
compete to better their relative valuations. The result could
be that while the basis between the two entities is reduced,
overall valuations might be as well, harming the entire TBA
market despite the best efforts of the FHFA. In addition, the
IRS has not ruled on the taxability of exchanges yet, leaving
investors in the lurch about what the changes might mean
for their portfolios. Meanwhile, market participants are still
working through a whole host of operational questions that
will need to be finalized well in advance of the June 3rd go-live
date. Thus while the change is a year away, investors should
be cognizant that the market could look quite different in just
a year, and it is not clear anyone will like what they see when
we arrive there.
