August Agency MBS Update

Monthly Commentary

September 07, 2018

Agency MBS experienced a late summer swoon in August, as fears of emerging market instability dragged on relative valuations. If an investor were to simply check the headlines and monitor U.S. equity markets movements, the final month of summer would appear to be a quiet one. U.S. stock markets appreciated, while U.S. Treasury rates rallied slightly. In addition, more-dovish-than-expected comments by the new chairman of the Federal Reserve, Jerome Powell, signaled to the market that the Fed may not be raising interest rates for as long as previously believed. A more dovish Fed and a positive month for U.S. risk markets painted a rosy picture for agency MBS performance in August. Yet beneath the surface the waters were not so calm. Emerging markets struggled in August, as numerous countries attempt to tamp down currency and economic crises. Turkey and Argentina are under particular scrutiny, although lagging economic data and fears of increasing tariffs are weighing on global developed markets as well. Volatility drifted upward as a result, as investors evaluated the increasing, though still small, probability that the current downturn in emerging markets will ultimately have an outsized impact on assets within the United States. Fears of global contagion permeated agency MBS ever so slightly as the agency MBS basis widened out. A quiet month in regulatory news and headline risk was not enough to keep relative returns in line. Ultimately, the Bloomberg Barclays MBS Index provided negative 14 basis points (bps) of excess returns in August, sending total year to date excess returns to negative 17bps overall.

Performance within the coupon stack was fairly quiet in August, the result of very little in the way of interest rate or regulatory shocks to the current status quo. Fannie Mae 30yr (FNCL) 4s were the best performer, closing down just 12bps relative to benchmark U.S. Treasuries. FNCL 3s and 4.5s could not keep pace, closing at negative 20bps and 28bps, respectively. FNCL 3s continue to be plagued by weak rolls and no issuance, as the coupon is far afield from where production mortgage rates currently sit in the U.S. FNCL 4.5s also suffered, as TBA dollar rolls fell during the month after previously trading special. Higher coupons have benefitted from elevated interest rates, which have spurred supply and liquidity in coupons such as FNCL 4s and 5s. Since there was previously relatively little supply, there were not many fast paying bonds that could be delivered into the roll. This allowed rolls to trade special and provided an additional tailwind to the coupon. Now that mortgage rates have been elevated for a more extended period of time, a larger supply of faster paying pools are starting to become deliverable, reducing carry and hindering valuations. The same impact can be traced to Ginnie Mae collateral. Ginnie Mae 30yr (G2SF) 4s and 4.5s posted excess returns of negative 23bps and negative 24bps, respectively. Slightly lower U.S. Treasury and mortgage rates hindered G2SF valuations slightly more than conventional coupons, the result of collateral differences that make conventional collateral more advantageous in times of increasing prepayments. Relative performance within the coupon stack was fairly contained in August, as investors looked for the next change in underlying coupon stack valuations.

The major regulatory news in August was the largely expected, but still newsworthy decision by the Internal Revenue Service (IRS) to classify exchanges by investors from Freddie Mac securities to “mirror” securities as a non-taxable event. The decision is the latest in a long and arduous march toward single security becoming a reality in the MBS market. The story dates back to when Fannie Mae and Freddie Mac were taken into conservatorship in 2008. The Federal Housing Finance Authority gained significant control over the operations of the two entities as part of that action. In 2012, the FHFA released a plan to create Single Security. The stated goal was to increase liquidity in the market by making Fannie Mae and Freddie Mac MBS mutually deliverable into one single TBA. The effort has trudged along slowly, as the market has attempted to understand the action and prepare for its consequences. When Freddie Mac was created, the intention was to foster competition between Freddie and Fannie to benefit consumers. Now the FHFA is essentially looking to do the opposite, making the two GSE’s securities identical while trying to standardize their prepayment speeds. This will mean that the GSEs will be discouraged from competing in any fashion other than service. All the while, the purported increase in liquidity is far from a given. The result is a highly reluctant marketplace that is attempting to absorb the costs of single security as best as it can. The IRS decision not to tax exchanges from Freddie Mac removes one of the last barriers to the FHFA going live with single security in June of next year. Should the FHFA not postpone the implementation of single security, the market should be prepared for unknown impacts, unless the best laid plans of men no longer go awry.

A generally quiet late summer in mortgage markets was not enough to push agency MBS performance into positive territory for the year. Instead, year to date performance relative to U.S. Treasuries continues to lag. This is despite continued low levels of interest rate volatility, combined with a decent buffer from any meaningful prepayment risk. The fact that the basis could not hold its own in this environment is somewhat telling. Agency MBS valuations continue to be influenced by the persistent low volatility that has taken hold over the past five years. Any time volatility picks up meaningfully, the agency MBS basis is likely to struggle. However, the precipitous drop in emerging market valuations does offer a useful tool to evaluate the relative merits of agency MBS. While other sectors are feeling significant symptoms, the agency MBS space merely has a light cold. Should a true flight-to-quality event occur, the principal safety of agency MBS may shine through relative to the majority of sectors in the fixed income universe. Thus, while increasing volatility is a powerful foe to agency MBS valuations, the sector could prove transcendent in the event of a more marked downturn in economic activity.


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