September Agency MBS Update

Monthly Commentary

October 04, 2016

The agency MBS basis once again posted positive returns in September, as continued low levels of volatility and global central bank support buoyed the sector. For the third consecutive month, after markets were riled by the United Kingdom’s vote to leave the European Union in June, calm prevailed in agency MBS. Interest rates rose during the first half of the month, driven in part by concern that the experiment in exceedingly easy monetary policy undertaken by most of the developed world might soon be at its end. Each of the three most influential global central banks met in September. The European Central Bank chose not to extend its quantitative easing program, which along with continuing gains in employment in the U.S. (+151k in non-farm payrolls), pushed interest rates higher on this side of the Atlantic. The resulting sell-off benefited agency MBS investors as prepayment risk dropped allowing the agency MBS basis to tighten. Japan was next on the docket, choosing to alter their experiment with quantitative easing, negative rates, and now yield curve control, until inflation outpaces 2% a year. The result of their program is that similar to Germany, Japanese government 10yr Treasury rates are slightly negative. The negative yields abroad have benefits to agency MBS valuations due to the positive carry profile agency MBS offers to foreign investors. Lastly, the FOMC had to make a decision as to whether the U.S. economy had shown sufficient improvement to warrant the first hike in the federal funds rate since December of last year. The Committee decided to hold off for now, signaling that they may look to raise interest rates later this year. This decision also proved beneficial to agency MBS investors. While low U.S. rates increase prepayment risk, they forestall the day when the FOMC will cease to reinvest pay downs of their agency MBS holdings. Ultimately, the dovish stance of the FOMC caused interest rates to fall back to the levels where they opened the month. The unchanged interest rates month over month allowed the enhanced carry profile of agency MBS to win the day, as continued low volatility provides a tailwind to the agency MBS space. Overall, agency MBS performance lurched farther into positive territory for 2016 in September. The Barclays MBS Index closed the month with outperformance relative to benchmark U.S. Treasuries of 18bps in September, closing the third quarter with year to date positive excess returns of 30bps.

Coming off of the best quarter for agency MBS this year, investors ought to be cautious as 2016 draws to a close. Low volatility, brought in part by Central Bank intervention and a recent lack of high profile market-shaping events, has allowed the agency MBS basis to climb into positive territory for 2016. On the surface, it also appears that if global central banks continue to produce easy monetary policy, agency MBS valuations will continue to appreciate. Yet Brexit demonstrated that low volatility can disappear quickly. Therefore it is important that investors remain vigilant to the possibility that the conditions which have tamped down volatility throughout that agency MBS space could fade in the near future. The overall lack of volatility was demonstrated within the coupon stack. Fannie Mae 30yr (FNCL) 3s-4.5s all returned between 15 and 28bps relative to benchmark treasuries, as the decreased price action hindered intra-coupon outperformance. Ginnie Mae (G2SF) collateral was generally in line with FNCL counterparts, with G2SF 3s returning 11bps and G2SF 4s returning a robust 28bps. The G2/FN 3.5 swap dropped from 24 to 22 ticks in September, as conventional 3.5s out-touched G2 3.5s at the end of the month. Roll performance was mixed, with the FNCL 3.5 roll dropping half a tick and the FNCL 3 roll appreciating by the same amount. The convergence of valuations between FG and FN collateral continued in September, as the FG/FN 3.5 swap appreciated from -2.5 ticks to just -.5 ticks. This trend very well could continue with a single security potentially on the horizon. Whether supportive tailwinds persist across the agency MBS coupon stack in the fourth quarter will be a very important trend to watch over the rest of 2016.

A very much awaited prepayment report, which represents the probable high point of the current wave of increased speeds, was released at the beginning of September. After much anticipation, speeds came in up 35% overall, as a higher day count combined with near-record low rates drove the spike. The increased speeds were primarily concentrated on lower coupons and recent vintages. FNCL 3 speeds were 39% faster, and FNCL 3.5 speeds came in even quicker up 52%. The faster speeds were really seen in the most recent vintages, with FNCL 3s issued in 2015 popping 77%, a full 22CPR faster since last month. 2014 remains the fastest vintage in aggregate, with 2015 issuance prepayments running a little slower. In Ginnie Mae collateral, the outcome was similar. Speeds increased in line with conventionals on a CPR basis, however due to the higher base prints, the 25.4CPR in September was merely a 25% increase over the previous month. The report also provided some insight into prepayments going forward, with most expecting a modest reduction in prepayments in the upcoming report. Mortgage rates have remained near 3.65% for nearly two months now, providing investors some clarity on the magnitude of this prepayment wave for the time being.

The one major regulatory event in September was the annual release of mortgage lending data as required under the Home Mortgage Disclosure Act (HMDA) for 2015. The data from most originators, while nearly a year old, provides a plethora of information on the overall trends seen in the mortgage market in the previous calendar year. In the 2015 report, there were a few takeaways that are worthy of mention. The first was that origination was up 34% in 2015, with new purchases up 18% and borrowers increasing their refinancing activity over 50%. The higher refinance activity was driven by a January of 2015 cut to the monthly insurance premium charged to borrowers in Federal Housing Authority mortgages, as well as the continued recovery of the housing market overall. A second takeaway is that fewer applicants were denied loans in 2015 than in previous years, continuing the trend seen since the nadir of housing crisis, namely, tight lending standards are once again slowly eroding. Finally the positive trend in purchase originations being slightly less robust in the northeast continued in 2015, with new loans only up 14% as opposed to the 18% seen in the south and Midwest. Ultimately the data in the report was not entirely surprising but provides investors a useful window into the macro trends that might prevail in the housing market going forward.

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

Source: Barclays, Bloomberg



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