September Agency MBS Update

Monthly Commentary

October 05, 2018

Agency MBS relative performance was positive in September as the late summer malaise that took the agency MBS basis wider in August reversed itself to close the third quarter on a high note. After a late August downturn in emerging market assets caused volatility to tick up and the agency MBS basis to widen out the story was reversed in September. Risk assets were far less jittery in September as investors shook off fears of contagion and sent stocks rallying once again. Strength in U.S. economic data further bolstered agency MBS relative valuations, with lower volatility further buoying performance. Mortgage rates rose throughout September to 4.97%, their highest levels since 2011. Higher U.S. Treasury and mortgage rates continue to keep prepayment risk muted, with index extension benefitting lower duration assets. The positive economic data caused the Federal Reserve to hike interest rates once again late in the month as the Fed continues to normalize monetary policy. The word “accommodative” was finally removed from the Fed’s press release, another ceremonial step in the winding down of the most expansive monetary experiment in history. Ultimately, the generally quiet month of news was conducive to outperformance by agency MBS. Lower volatility and the specter of modestly higher interest rates sent agency MBS relative performance into positive territory for the month. In total, the Bloomberg Barclays MBS Index returned 11 basis points (bps) in September, bringing year to date excess returns to negative 7bps. Absolute returns continue to struggle, with year to date total returns at negative 1.07%.

Positive performance permeated the coupon stack in September, with higher coupons outperforming their lower coupon counterparts. FNCL 4.5s posted excess returns of 24bps in September, while FNCL 3.5s came in up 7bps. Mortgage rates that ticked up were particularly beneficial for higher coupon collateral in September. FNCL 4s and 4.5s continue to benefit from increasing production after years of elevated prepays and high dollar prices that have hindered performance. Lower coupons also outperformed benchmark U.S. Treasuries despite higher rates, as the rising tide of agency MBS performance kept all coupons in positive territory. Ginnie Mae collateral also posted strong relative returns; Ginnie Mae 30yr (G2SF) 4s and 4.5s came in at 16bps and 24bps of positive performance respectively. The lower credit quality of Ginnie Mae collateral limits extension risk under elevated interest rate scenarios, which buoyed the collateral in September. Across all agency MBS coupons, one of the biggest stories is the diminishing attractiveness of TBA roll implied financing rates. When the Federal Reserve started buying TBA and taking delivery of pools, the result was all the worst-to-deliver bonds ended up on the Federal Reserve’s balance sheet. This made TBA rolls very attractive for most agency MBS investors who could own TBA without the downside of fast paying pools being delivered. With the Fed very close to ceasing agency MBS purchases altogether, the worst-to-deliver bonds are returning to the float for the first time in many years. One likely impact of this factor is TBA roll levels may diminish over time. Lower TBA roll drops could negatively impact coupons across the agency MBS coupon stack, particularly where the TBA deliverable has been dependent on Federal Reserve action for positive performance.

The most pervasive topic in regulatory circles remains the push to get Single Security orchestrated and implemented by June of next year. While the basics of the FHFA’s directive to make Fannie Mae and Freddie Mac bonds deliverable into one single TBA have been known for some time, the FHFA is now scrambling to get all of their loose ends tied up in time to go live with the plan in June of 2019. Initial steps were taken to allay one of the market’s largest concerns in September. An initial rule was proposed to force Fannie Mae and Freddie Mac to align prepayment speeds associated with each cohort, as well as many other business practices. The rules are intended to make it exceedingly difficult for one agency to compete in any financial manner with the other, with the FHFA monitoring prepayment speeds and regulating guarantee fees. In theory, the rules will make it easier for the market to digest Single Security. Investors will have codified language keeping the two GSEs business practices aligned with each other. Yet in practice, it is far from clear that having two entities that previously existed to rival one another no longer be allowed to engage in financial competition is in the best interest of homeowners across the nation. That being said, the destination of Single Security remains foremost on the mind of regulators, and at the moment they are the ones getting to drive the train to their preferred destination.

The end of the third quarter offers an opportunity to reflect on the year to date for agency MBS. Relative performance has been in negative territory throughout the year, and total returns have struggled due to shifting interest rates. The 10yr U.S. Treasuries closed back above 3% at the end of September, coming from under 2.5% at the beginning of the year. The first quarter of 2018 was where most of the damage was done to relative valuations; historically low volatility from the latter stages of 2017 was undone by higher rates and flurry of global market concern. While volatility faded in the second and third quarters of the year, the agency MBS basis rallied back. With the third quarter of 2018 now in the rear view mirror, four of the last five quarters have been characterized by exceptionally low volatility. Does this new, more repressed level represent a new status quo for interest rate volatility? Or should investors look to other periods to determine the most likely course of volatility going forward? While either answer is plausible, we generally subscribe to the latter view. While it is impossible to know when volatility will revert toward historically higher levels, it is likely that agency MBS investors will confront an environment of increasing volatility going forward.

 

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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. © 2018 TCW