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
