February 17, 2017
The post-election rise in market rates has substantially decreased the primary risk for Agency MBS investors: cash flow uncertainty due to voluntary prepayments. After years of declining rates, the majority of borrowers have taken advantage of lower rates by refinancing. Going forward, the market’s post-crisis refinancing exposure has decreased dramatically. Investors have reacted by holding pricing spreads at the low end of the post-crisis range. In addition to declining prepayment-induced refinancing risk, an altered market structure since the crisis has contributed to the recent historically low spread range. A combination of restrictive regulations, ongoing litigation and a changing market buyer base has altered the post-crisis historical Agency MBS and Treasury basis relationship. Absent a substantial 2017 decline in interest rates, prepayment risk will be driven by wage and employment-related variables such as purchase share turnovers, mobility, and first-time homebuyers entering the market. These slow-moving variables will support current spread levels, and any potential widening will fall well below pre-crisis levels. Risks to this view are repricing due to extension risk and the risk of the Fed tapering reinvestment of MBS principal. However, the majority of extension risk has already occurred, and unless the Fed is willing to risk a housing market fallout after years of recovery, a 2017 Fed MBS tapering event is only a remote possibility.
With the decline in rates since the financial crisis, the “coupon stack” of the mortgage market reflects the refinancing activity that has taken place. In 2008, 87 percent of MBS had a 5–6 percent coupon. Today, 81 percent has a 3–4 percent coupon.
Source: Wells Fargo, Guggenheim Investments. Data as of 12.31.2016.
After positive performance in the first three quarters, Agency MBS lost 2.0 percent in the fourth quarter, bringing the year-to-date return for 2016 to 1.7 percent. Yields rose sharply in the aftermath of the election and currently stand at 2.85 percent, the highest level since the fourth quarter of 2014 and above the average yield of 2.60 percent over the last five years.
We prefer a combination of conventional 15- and 30-year MBS for duration management, and we find value in low pay-up call protection pools. Specified pools priced near their respective TBA coupons provide a good balance between yield and prepay protection in the event of a flight-to-quality event. We continue to avoid most premium priced loan-to-value pools as home price appreciation will continue to erode the protection initially afforded to these bonds.
Reduced refinancing risk and an evolving market structure have contributed to the recent, historically low spread range. Risks to this view include extension risk and an early tapering by the Fed of its reinvestment of MBS paydowns.
Source: Bloomberg, Guggenheim Investments. Data as of 1.11.2017.
—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Director
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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