November 26, 2018
During the past trading week, yield spreads on current production coupons to Treasuries resumed their widening trend that has been in place for much of 2018. The cheapening trend has elevated yield spreads back to levels last observed during 2013 for the 30-year sector and early 2017 for the 15-year sector.
In recent weeks we’ve seen an acceleration of two-way flow (investors selling and buying). The selling has been spurred on by investors preparing their balance sheets for year-end and positioning their portfolios for improved performance. Given that some institutions are ahead of their 2018 budget and the fact many portfolios contain securities with book yields below current market yields, attention has shifted to portfolio restructure transactions that have the potential to boost 2019 income. The general thought is to sell lower yielding securities at a loss and use proceeds to purchase higher yielding instruments that will provide improved levels of interest income in future periods.
Because of the back-up in rates, the balance of the MBS market has shifted from being largely priced at a premium beginning in 2018, to trading at a discount currently. As a result, the overall theme in the MBS market continues to be lower dollar prices, wider spreads, and finding relative among discount stories. Investor demand reflects this theme as most of the recent buying has been focused on lower coupon 15- and 20-year passthroughs trading at a discount. The lower coupons tend to have better convexity profiles (less negative) relative to higher coupons and longer WAMs. We have also seen consistent demand for off the run collateral (high-loan-to-value, jumbo, and relocation loans).
The following represents a summary of the activity over the past couple of weeks:
- Seasoned 10-Year 2.5s and 3.5s – There continues to be strong bank demand in this sector because of the defensive nature of these structures.
- Seasoned 15-year 2.0s to 3.0s – The flat yield curve and relative value in these coupons has driven investors to this segment. There continues to be a relatively small pay up over TBA for pools with seasoning between 18 to 36 months. In some cases, investors can potentially receive less price volatility and greater stability of cash flows relative to new pools, for a modest trade-off in projected yield. Please see a recent Strategic Insight discussing the current merits of slightly seasoned, below par 15-year MBS.
- 20-Year 3.0s and 3.5s – Yield buyers have focused on new production 20-year 3.5s trading just under par.
- 30-Year 4.0s and 4.5s – Several trades in new production pools backed by jumbo-conforming loans.
- FNMA DUS and Freddie K’s – Agency CMBS has been the fastest growing sector in bank portfolios for the past several years. The focus last week for FNMA DUS was on 7- to 11-year finals. Yield spreads on Freddie K’s have widened sharply over the past two months and investors are targeting 3- to 5-year finals. There has also been steady demand for floating rate structures (FNMA Aces and Freddie K’s in which the fixed-rate cashflow has been swapped out for floating-rate cashflow).
- HLTV Fannie 30-yr 3.0s and 3.5s – The potential for higher turnover has attracted buyers to this sector. Prepays of high LTV collateral are likely to be steeper than those of lower LTV collateral. A portion of this collateral is represented by borrowers that used the HARP refinance program. As home prices have appreciated, the current LTVs for higher LTV collateral have migrated lower. As a result, the borrowers are incentivized to refinance much faster than the low LTV collateral because of the payment savings resulting from lower MI payments (more than rate incentive alone). Alternatively, when home prices decline these borrowers would become eligible for the streamline HARP program replacement, which would lower the costs of refinancing because it will require no appraisal and little to no credit underwriting. In other words, the high LTV collateral is likely to exhibit higher turnover compared to low LTV as long as home prices appreciate or depreciate.
- MBS pools – The MBS desk routinely creates custom MBS pools to assist financial institutions with the Community Reinvestment Act requirements.
Mortgage Rates and Refinance Activity
- Benchmark mortgage rates were mostly stable last week (11/23).
- 15-year mortgage rates decreased 1bps to 4.00%, 26bps above the 12-month average of 3.74%, and 20bps above the YTD average of 3.80%.
- 30-year mortgage rates increased 1bp to 4.76%, 40bps above the 12-month average of 4.36%, and 34bps above the YTD average of 4.42%.
- 15-year mortgage rates have increased 80bps in 2018, while 30-year mortgage rates are up 91bps YTD.
Mortgage Applications: Although mortgage applications dipped (-0.1%) for a sixth time in the last seven weeks, there was a hint of positivity for a sector searching for the smallest piece of good news. The small monthly decline was driven entirely by a 5.0% drop in the refi index to an 18-year low, while purchase applications actually recovered 3.1%. Still the purchase index remained at one of its weakest levels since the summer of 2016. Although it was small, the MBA’s 30-year contract rate dropped 0.01% from the prior week’s 5.17% rate that marked an 8-year high for the series. The decline to 5.16% was the first in seven weeks.
Existing Home Sales Rose for First Time in Seven Months: Existing home sales finally broke out of their mid-year slump with a slightly firmer-than-expected 1.4% MoM increase. October’s gain was the first since March and just the third for all of 2018. Looking at the data regionally, three of the four regions saw a rebound from notable drops in September, including a 1.9% gain in the South, the biggest contributor to total sales. While October’s gain is an obvious positive for a sector struggling for any good news, it will take more than a single data point to break the downtrend and shift the narrative away from expectations of slower sales. The 5.2MM SAAR sales pace was the second weakest since 2016.
Michael S. Erhardt, CPA
Senior Vice President
Vining Sparks, IBG