April Agency MBS Update

Monthly Commentary

May 04, 2018

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.


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