September 21, 2020
The Fed kept rates unchanged last week and continued to say they will increase their holdings of Treasury securities and agency MBS at the current pace, approximately $80bn in Treasury securities and $40bn in MBS each month. However, they amended that plan to also say they will “increase holdings of Treasury securities and agency MBS by additional amounts… as needed to sustain smooth functioning of markets for these securities.”
The Fed has purchased over $1tn of agency MBS securities since the start of QE4 in mid-March and they are on track to purchase $1.4tn to $1.5tn by year-end. This is nearly the same amount as they purchased in aggregate during the former mortgage QE periods combined. Since the beginning of QE4, the Fed’s ownership of agency MBS has increased from 21% in late March to approximately 29%. The Fed’s sponsorship of the sector has led to reduced volatility, higher prices, and tighter spreads.
Current Yield Spreads
Yield spreads on production coupon MBS compared to Treasuries widened last week. Nominal spreads on both 15- and 30-year MBS to Treasuries widened 8 bps to 41 bps and 75 bps, respectively.
Prepayment risk is the main concern for MBS investors as premiums remain high from the support by the Fed. Fannie Mae recently reported that using a 2.93% driving 30-year mortgage rate, that 64% of all mortgages are at least 50 bps in the money, and this rises to 77% when looking at conventional mortgages only. Even more troubling, these figures are with the primary/secondary mortgage spread being approximately 45 bps over the five-year trailing average. Lenders have the spread elevated to manage risk and capacity.
To help mitigate prepayment risk MBS buyers have focused on lower coupons and pools with characteristics that make prepayments less likely (low loan balances, 100% NY, low FICOs, investor loans).
The summary below reflects trading activity from last week. We’ve also seen consistent selling of MBS to monetize unrealized gains with some repositioning into lower coupons and/or other collateral with prepayment friction. Selling TBA-eligible MBS remains attractive due to the significant Fed support of liquidity and pricing.
- UMBS 15-year 1.5’s to 3.5’s (1.5’s the most traded)
- UMBS 20-year 1.5’s & 2.0’s (2.0’s the most traded)
- UMBS 30-year 2.0’s to 3.0’s (2.5’s the most traded)
- FNMA Jumbos (FNCK 2.0’s to 3.0’s)
- GNMA Jumbos (MJM 2.5’s & 3.0’s)
- 15- and 30-Year 1.5’s to 3.0’s LLB Pools ($85k -$200k max loan size)
- Custom CRA Pools
Given the robust refinance activity, portfolio managers continue to seek prepay protection to avoid potentially low or negative yields. Many investors have turned to specified pools (lower loan balances, NY collateral, investor loans) to help partially mitigate faster prepay speeds. The graph below highlights monthly prepayment speeds on different collateral types.
Mortgage Rates and Refinance Activity
Mortgage rates continued to hover near their historic lows last week. According to Bankrate.com, the 30-year fixed-rate mortgage decreased 4 bp to 3.01% while the 15-year mortgage rate declined by 7 bps to 2.48%. In Freddie Mac’s rate survey, which includes points/fees, the 30-year rate increased 1 bp to 2.87%, which is just 1 bp higher than the record low.
Mortgage applications for the week ending September 11 fell 2.5% on a 0.5% drop in purchase apps and a 3.7% decline in refis. The refi index remains elevated and is 30% over the same week last year.
The primary/secondary mortgage spread drifted lower last week by 4 bps to 1.65%. The level remains 15 bps over the trailing one-year average of 1.50% and 45 bps over the trailing five-year average of 1.20%. Mortgage rates have additional room to decline further if we see a reversion in the primary/secondary spread.
Michael S. Erhardt, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP