August Agency MBS Update

Monthly Commentary

September 06, 2019

Agency MBS posted its worst performance of the year in August as lower interest rates and significant supply, amid volatile markets, proved to be too much of a headwind. Several catalysts pointing to lower rates continued to act unabated as signs of economic stress appeared across the globe. The trade war between the U.S. and China showed no signs of improvements with President Trump imposing additional tariffs and China allowing its currency to decline to more than 7.0 to a dollar. In Asia, protests in Hong Kong and the trade war between South Korea and Japan escalated rapidly throughout the month. It was not any better in Europe with Italy’s government collapsing and increasing signs of a disorderly Brexit. The ensuing rise in volatility buoyed safe haven assets while the prevalent narrative pivoted from global recovery toward global slowdown. The S&P 500 came down from all-time highs while the 10 yr Treasury yield rallied 52 basis points (bps). The widely watched spread between the yield on the 2 yr UST and 10 yr UST, considered an indicator for recession, inverted for the first time in 14 years and ended the month at -1 bps. For Agency MBS, performance leaked wider throughout the month due to sharply lower rates, higher MBS supply, and weakening dollar rolls. The Bloomberg Barclays MBS Index underperformed benchmark U.S. Treasuries by 63 bps for the month while yearto- date total return remained strong from the interest rate rally at 6.7%.

The August prepayment report caught the market off guard as it surprised on the upside with the 30 yr conventional MBS prepayments for July coming in 29% higher than in June. The pickup in speeds was particularly noticeable for the 2018-2019 vintage cohorts with the 2018 vintage spiking 70% month over month. With the 10 yr rate dropping an additional 52 bps this month, prepayment concerns remain elevated in the market. However, the Freddie Mac Primary Mortgage Market Survey (PMMS) 30 yr fixed mortgage rate, did not fall as much as the 10 yr rate. It ended the month only 17 bps lower at 3.58%. The smaller move in the 30 yr fixed mortgage rate is reflected in the secular wides of the Primary-Secondary Spread, which measures the difference between the average 30 yr fixed rate and a representative yield on a newly issued agency MBS (Current Coupon MBS). Although there are some complexities in measuring this spread, such as estimating the yield of the Current Coupon MBS, calculations show the spread to be at multi-year wides as the 30 yr fixed mortgage rate lags the broader interest rate rally. The main reason for the lag seems to be a capacity issue as originators were not able to hire fast enough when interest rates took a nosedive in the summer. If rates were to remain in this range, the base case should be for tighter Primary-Secondary Spread levels and thus lower 30 yr fixed rates.

The secondary effect of lower rates caused origination supply to increase as we saw average origination exceed $4bln a day. Month-to-month origination rose 19% to $91bln, weighing the lower coupons down as supply shifted heavily towards the lower coupons. The two coupons with the most supply were the worst performers with FNCL 3.0s and 3.5s posting 82 bps and 88 bps of negative excess returns, respectively. Higher coupons performed marginally better for another month as supply dwindled with FNCL 4.0s down 49 bps and FNCL 4.5s down 55 bps. GNMA MBS outperformed its conventional counterparts (FNMA and FHLMC) this month as GNMA speeds were rather contained and closer to expectations. Although GNMA securities tend to be shorter in duration and should underperform in a rally, they outperformed conventionals throughout the month. Servicer efficiency coupled with a worsening TBA float has effectively created a paradigm shift where conventional securities are now projected to have a prepayment ramp as steep as that of Ginnies. While the market readjusted valuations, Ginnie Mae securities outperformed throughout the stack with G2 4.5s being the best performer at negative 18 bps of negative excess returns.

FN/FH/G2 4.0% CPR Ramps

Source: TCW, eMBS


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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