March Agency MBS Update

Monthly Commentary

The agency MBS basis widening that characterized the opening two months of 2016 was halted in March, as a shifting market dynamic failed to further unsettle market participants. The month can reasonably be divided into two halves in terms of interest rate positioning. The opening of March saw risk assets and interest rates rise. A strong non-farm payroll report (+242k) and the European Central Bank decision to forego future rate cuts sent the 10yr U.S. Treasury yield up 26bps to 1.99%. The second half of the month saw the U.S. Treasury selloff reverse, with the Federal Reserve striking a notably dovish tone while choosing not to raise interest rates. Furthermore, the reduction in growth forecasts both in the United States and abroad helped U.S. Treasuries rally back to within 6bps of where they ended February, finishing with the 10yr at 1.79%. Based on how the agency MBS basis has traded in recent months, it might be expected that there was a sustained rally in the agency MBS basis as rates rose, and rapid widening over the past two weeks as prepayment fears returned to the market. However what was most notable about March was the manner in which the agency MBS basis broke from trading patterns early in March that have persisted in recent months. Specifically, there was not nearly as much tightening as one might have expected as mortgage rates rose early in March. The key factor was the increasing risk that the Federal Reserve might choose to wind down more quickly the extraordinary monetary policies that have buoyed mortgage valuations in recent years. Despite the lower interest rates that have resulted from quantitative easing and the Fed lapping up agency MBS pools, the reduced volatility has bolstered mortgage valuations. On the day that the Federal Reserve chose not to raise benchmark interest rates, instead striking a dovish tone, agency MBS outperformed by a quarter of a point relative to Treasuries that also were rallying. The remainder of March saw a return to previous patterns, with the mortgages widening into a sustained treasury rally. This differentiation in what drove agency MBS performance mid-month is important for investors to watch for going forward, as the lower rates that drive prepayments might yet remain beneficial to valuations if coupled with lower volatility caused by the long arm of Fed policy. Ultimately, the Barclays MBS Index outperformed by 15 basis points relative to U.S. Treasuries in March, reducing underperformance for the year so far to -38 basis points. Going forward, it may yet come to pass that the potential decoupling of the basis from U.S. Treasury performance proves to be among the most important developments from March.

The coupon stack performed admirably given the difficult conditions in March, with all Fannie Mae 30yr (FNCL) coupons outperforming their 10yr U.S. Treasury hedge ratios (HRs). FNCL 3.5 came in up 13 ticks relative to HRs, with FNCL 4.5s right in line closing up 12+ ticks. Looking at duration adjusted coupon swaps, higher coupons did end up outperforming their lower coupon counterparts, with the FNCL 4.5/3.5 swap closing up 7 ticks in March. FNCL 5s and higher, while posting positive hedge adjusted returns, were the only collateral that did not keep pace with the rest of the stack. 15yr FNCI coupons also demonstrated strength, with FNCI 3s ending up 13 ticks relative to their HRs. Slower than expected prepays aided the positive performance, but as with 30yr collateral, higher coupons did not keep pace. The performance was similarly robust in Ginnie Mae (G2SF) collateral, led by lower coupons that outperformed their higher coupon counterparts. G2SF 3.5s closed up 15+ ticks, with G2SF 4 also outperforming HRs to the tune of 11+ ticks. Slightly higher rates were beneficial to the G2SF stack, as G2SF collateral tends to outperform when U.S. Treasury yields rise. This very mild outperformance can be seen in the G2/FN 3.5 swap, which rallied 5 ticks in the first half of the month before summarily declining as mortgage rates came down in the last two weeks to close up half a tick at 27. The potential for further Federal Reserve extension was positive for the Freddie Mac (FG)/FN 3.5 swap, which rallied from -7 to -5 ticks in March. Ultimately, the coupon stack performed relatively well in March, as the most liquid coupons outperformed their hedge ratios to close the quarter on a positive note.

The February Prepayment Report released at the beginning of the month was supportive of agency MBS valuations. Fannie Mae 30yr (FNCL) speeds rose 11% during February to finish at 10.5CPR. This was below many street estimates that had presumed that prepayments would come in even faster, given that the day count increased and driving rates were down slightly during the period. The primary driver of the slower speeds was in higher coupons, with FNCL 4.5s and FNCL 5s only up 2% in February. Speeds did increase significantly in some newer vintages, with 2015 FNCL 3.5s rising 59% to 6.7CPR. The key driver of this change was due to the larger loan sizes in newer cohorts, which make the incentive to refinance more valuable to those borrowers. Similar to FNCL collateral, Ginnie Mae 30yr (G2SF) collateral printed speeds that were below expectations. G2SFs in aggregate were up just 6% in February, with G2SF 3.5s up a full 16%, but G2SF 4.0s rising only 3%. These results supported the outperformance throughout the coupon stack in March. Turning to the 15yr space, prepayments came in even slower than their 30yr counterparts. FN 15yr collateral prepaid only 3% faster than in January, closing at 8.7CPR. As the calendar turns to April, it is expected that some of the speed increases that did not manifest themselves in February will filter into the March report. The day count will increase once again, which when combined with higher seasonal factors should lead prepayments to speed up significantly, possibly by 25% in March.

The regulatory landscape was once again altered by the comments of the Director of the Federal Housing Finance Agency (FHFA), Mel Watt. On March 22nd, he addressed the challenges facing the Home Affordable Refinance Program (HARP) that is set to sunset in December. Last discussed in this space in January, there is tremendous intrigue as to what might replace HARP, and what types of securities might be affected both negatively and positively by any changes introduced by a new program. The most pressing concern in the market had been the chance that the FHFA might allow borrowers with high loan to value (LTV) ratios who had previously used the HARP program to re-HARP, or use the program again to get a lower mortgage rate. This would have had a negative effect on the various securities that contained those loans, and left investors who had paid premiums for mortgage pools with high LTV collateral with potential losses. Mel Watt’s speech explicitly ruled out the possibility of re-HARPing, saying quote, “We are reminding industry participants that borrowers who previously completed a HARP refinance will not be eligible to refinance under a new high-LTV program.” This raises a significant regulatory weight off of the agency MBS market, as the possibility that the largest downside scenario facing any new program will not come to fruition. Director Watt also stressed that the goal of the program would be forward looking, which if true would limit the potential for large scale changes to valuations around current securities. This, in combination with closing the door on re-HARPing, made for a positive month in agency MBS regulatory changes.

Agency MBS Basis vs. 10yr U.S. Treasury Yield

Source: Barclays, Bloomberg

Coupon Stack Performance

Sources: TCW, Barclays, JPMorgan

Benchmark Performance

Sou​rces: TCW, Citigroup

Issuer Performance (ticks)

Sources: TCW, Credit Suisse, JPMorgan

Specified Pool Pay-up Grid (ticks)

MHA/LTV Pay-up Grid (ticks)

Sources: Goldman Sachs, Deutsche Bank and Credit Suisse as of 3/31/2016
Indication Only