July Agency MBS Update

Monthly Commentary

August 02, 2016

The agency MBS basis found slightly better footing in July after a tough end to the first half of 2016, as improving macro data helped drive a recovery in global risk assets. After yields around the world fell precipitously on weak economic data and United Kingdom voters surprisingly decided to leave the European Union at the close of June, markets remained on edge as July began. The key factor concerning agency MBS investors is the potential for a spike in prepayments as the lower yield levels seen across the globe filter through in the form of reduced mortgage rates. As rates in both Japan and Germany traded further into negative yield levels, the agency MBS basis widened out in the opening days of July. A strong non-farm payroll report (+287k) alleviated lingering concerns about the strength of the US economy, allowing the spread between agency MBS and US Treasuries to tighten as the 10 yr US Treasury yield backed up from 1.38% to a high of 1.58% through the middle of the month. As July drew to a close global yields began to fall once again. Weaker than expected US second quarter GDP (+1.2%), followed by the Fed remaining somewhat dovish in their economic outlook, negated much of the uptick in monthly data seen earlier in July and hindered valuations. Ultimately the agency MBS basis ended up ever so slightly tighter in July, allowing the superior carry profile of mortgages to win the day relative to US Treasuries. In aggregate, the Barclays MBS Index posted returns of positive 13 basis points relative to benchmark US Treasuries, bringing the year to date return to negative 22 basis points for 2016.

One notable trend in agency MBS performance was the degree to which the agency MBS basis has held in while US Treasuries have rallied to near record low yields. One might have expected agency MBS performance to lag more meaningfully in the face of a potential prepayment spike in the coming months. Two factors have contributed to mortgages holding their ground relative to US Treasuries. The first is the continued sponsorship of the Federal Reserve, which continues to reinvest pay downs of their portfolio into the agency MBS market. This has allowed the carry profile of agency MBS to remain strong as the fastest paying pools have tended to wind up in the hands of the Federal Reserve. The second byproduct is that as yields globally have continued to fall, investors have reached for yield by investing in the higher nominal yields available in the agency MBS market. Furthermore, the Fed has signaled that they will continue to reinvest pay downs until rates normalize, which for now means that lower yields have resulted in a prolonged period of Fed intervention. The challenge remains that these technical factors supporting agency MBS valuations are not necessarily permanent features of the market and therefore vigilance should be warranted for agency MBS investors going forward.

Coupon stack performance reflected the higher overall rates seen in July, as lower coupons slightly outperformed higher coupons in conventional 30 yr MBS. With production coupon pools being the most likely to be refinanced if interest rates drive below current levels (30 yr fixed mortgage rate at 3.67%), Fannie Mae 30 yr (FNCL) 3s through 4s have been the most reactive to rates in the current environment. 3s returned 32 bps relative to benchmark US Treasuries while FNCL 4s only returned 3 bps in excess returns in July. The story was the same in Ginnie Mae collateral, as G2SF 3s provided excess returns of 52 bps in June, but G2SF 4s came away with negative 8 bps in returns in excess of benchmark US Treasuries. As the effects of lower mortgage rates hit prepayments in both July and August, FNCL 3s, 3.5s, and 4s could come under pressure if prepayments are faster than anticipated. Speed increases could also negatively impact lower coupons roll levels, which continued to trade poorly throughout July. Ultimately, prepayments could have an outsized impact on coupon stack performance going forward, depending primarily on how aggressively homeowners exercise their option to refinance their mortgages.

The penultimate prepay report before lower mortgage rates are reflected in the market came through at the start of the month, with Fannie Mae (FNCL) speeds increasing 9% and paying at 17.1 CPR overall. Freddie Mac speeds were slightly slower at 16.9 CPR to finish up 8% from May. Most of the speed increase was driven by both a higher day count in June and seasonal factors. FNCL 3s were up 13% while FNCL 4s were up 8% to pay at 11.1 CPR and 20.8 CPR respectively. Ultimately the report was generally in line with expectations. This left investors to ponder what details the next prepayment report will contain. The day count will be two days lower in July, reducing headline speeds, although the beginnings of faster future speeds could percolate. In addition, there are some factors that might cause speeds to lag relative to the prepayment wave of 2013 when mortgage rates were last at this level. Most importantly, borrowers who refinanced in that wave are mostly not currently ‘in the money’ and will not be able to refinance unless mortgage rates were to drop further. Compounding the point, the refinance index currently is less than half of the highest level that was reached in 2012. Ultimately, rates have fallen to the level where prepayments are once again rising in importance to both coupon stack positioning and overall market valuations.

The regulatory front saw some new announcements by the Federal Housing Finance Agency (FHFA) regarding the ongoing attempt to create a common securitization platform to combine Fannie Mae and Freddie Mac TBA into a single security. Formally proposed in 2014, the July release from the FHFA gave more clarity to investors on the timeline for the combining of the two TBA markets as well as some announcements about their decision making regarding some of the more trying aspects of the project. The timeline appears to involve the two government sponsored entities (GSEs) being prepped for a single security to take effect near the end of 2018 or early in 2019. More notable was the FHFA’s announcements that they will get the two GSEs to agree on a common set of rules to align their prepayment rates going forward. This was one of the biggest roadblocks to the arduous task of getting two competing entities to come together to improve market liquidity. In aggregate, this announcement means it is now likely that a single security will in fact become a staple of the agency MBS market in the not too distant future.

FNMA Current Coupon Nominal Spread vs. UST 5s/10s Blend

Source: Barclays, Bloomberg

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