October Agency MBS Market Update

Monthly Commentary

November 03, 2017

The month of October was relatively quiet in agency MBS, as the beginning of balance sheet reduction was mitigated by muted volatility and slightly elevated interest rates. After a strong September and a volatile third quarter overall, the agency MBS basis was quiet in each week during October. The month opened with a negative non-farm payroll figure (-33k), with multiple hurricanes negatively impacting employment in September. The negative payroll number was one of the only pieces of bad news across the month of October. The balance of economic data buoyed risk market valuations, as investors gained optimism about the speed and strength of the U.S. economic growth. The U.S. Treasury curve continued to flatten on the optimism, impacting coupon stack performance and shifting even more attention to the upcoming appointment of a new chairperson of the Federal Reserve. Speculation about the appointment and the beginning of balance sheet reduction were two of the biggest storylines in October. While the commencement of balance sheet reduction did not roil the agency MBS basis in October, the beginning of the process is a milestone in the years-long road to policy normalcy. Debate about the next Chairperson of the Fed, on the other hand, impacted agency MBS performance. Consideration of current Chair Yellen, in combination with candidates thought to be as hawkish as Professor John Taylor caused multiple yield curve shifts and valuation shifts in the MBS coupon stack. As is often the case in markets, the fact was not nearly as noteworthy as the rumors. President Trump ultimately chose Jerome Powell to succeed Janet Yellen as Chairperson of the Federal Reserve. Thought to have some philosophical similarities to Yellen, it is not clear that Fed policy will shift notably with respect to the balance sheet or the setting of interest rate under his leadership. The net result was like most of October, a few small moves with very little to show in terms of relative performance. In aggregate, the Bloomberg Barclays MBS Index outperformed benchmark U.S. Treasuries by 4 basis points (bps) in October, bringing year to date excess performance to 32bps in 2017.

The coupon stack was similarly close to home in terms of monthly excess performance. The U.S. Treasury curve flattened by 8bps in October, aiding lower coupons and driving them to slight outperformance in both conventional and Ginnie Mae collateral. Fannie Mae 30yr (FNCL) 3s outperformed benchmark U.S. Treasuries by 11bps in October, while FNCL 4.5s provided -7bps in excess returns. The lower coupon outperformance occurred despite rising mortgage rates. The 30yr mortgage rate increased to 4.22 in October, marking the highest level since mid-July. Previously in 2017, elevated mortgage rates had been correlated with higher coupon outperformance. The divergence in the trend, while a relatively benign shift, was a notable one in October. In issuer performance, Ginnie Mae trailed conventional MBS, especially in higher coupons. Higher coupon Ginnie Mae collateral is subject to the highest degree of regulatory uncertainty, and therefore relative performance may be more volatile than in conventional MBS in the near term. Now that the Fed is reducing its holdings of MBS securities, the market will have to shift to the new reality of a less intrusive Federal Reserve. As the process gains steam, how TBA rolls react will be a key indicator of the shifting landscape. The Fed has been taking in the fastest paying and worst to deliver pools since they began buying agency MBS after the financial crisis. The result was a TBA roll market that was more likely to trade ‘special’, meaning investors could get above-market returns for rolling TBA. Many expect that TBA roll levels perform poorly over time as the Fed reduces its balance sheet and ceases taking in the fastest paying pools. Presuming rolls do underperform, investors will need to find increasingly creative strategies to obtain above market returns in the agency MBS space.

The regulatory story that continues to most impact agency MBS valuations is the ongoing saga over incredibly fast speeds in higher coupon Ginnie Mae MBS, specifically in loans issued through a Department of Veterans Affairs program to help Veterans and their families obtain home loans. The prepayments on these loans have been remarkably high in many cases, as lenders have attempted to increase their fees by refinancing Veterans in the program repeatedly, making investors less willing to hold the resulting Ginnie Mae collateral. In September, Ginnie Mae announced that they would be investigating both the general practices and perhaps specific lenders to ensure that nothing untoward was happening with regard to Ginnie Mae prepayments. This month, there were further developments. Specifically, Ginnie Mae announced a joint task force with the Department of Veterans Affairs to help root out “loan churning and repeated refinancing.” There are numerous ways that Ginnie Mae could target the problem. The most probable action is a net benefit test that would force lenders to ensure that refinancing a loan is actually financially advantageous to the borrower prior to proceeding. There is also discussion of targeting individual lenders with particularly fast speeds. The market will continue to watch how aggressive the task force is in reducing prepayments in Ginnie Mae collateral, as the exact nature of the new rules will impact both pools and TBA securities throughout the Ginnie Mae coupon stack. With prepayments remaining benign, and much of the regulatory cloud unlikely to be resolved before the calendar flips to 2018, the path of Ginnie Mae valuations will be a must-watch storyline for the remainder of the year. As the calendar year begins to wind toward its inevitable conclusion, agency MBS will look to hold on to its year-to-date outperformance, reversing the slightly negative relative performance of 2016.


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