Focus on Longer Duration

The widely feared refinancing wave failed to materialize, but Fed timing remains a risk.

December 15, 2016

This sector report is excerpted from the Fourth Quarter 2016 Fixed-Income Outlook.

As the 10-year Treasury rate hit historical lows in the third quarter, concerns arose that the Agency MBS market would revisit its 2012 refinancing wave. However, the borrower incentives needed to reach the same prepayment levels did not exist: Public data releases reflecting borrower prepayment behavior lag actual interest-rate moves by over a month and the subsequent data demonstrated the impact was much less than previously witnessed at similar rate levels. The impact of prepayments is the primary risk driver that determines the spread over similar U.S. government-backed paper, and the spread tightening that followed the data release reflects this increasingly manageable risk. While concerns over prepayment risks are diminishing, there are still questions regarding the Fed’s portfolio, which contains approximately 30 percent of the entire Agency MBS market. A renewed focus on the possibility of a faster pace of hikes could reignite market speculation over the potential that the Fed will sell assets from its current portfolio. Notwithstanding this concern, spreads have moved toward the lower end of the past three years as some investors are calling for up-in-quality asset positioning into a rate hike environment. A technical picture supported by seasonal supply declines, sluggish growth in credit availability, and the aforementioned diminishing levels of prepayment risk are also driving this strong performance.

Prepayment Speeds Defy Market Expectations

The last time 10-year Treasury yields were near August 2016 lows of 1.36 percent was in July 2012. At that time, prepayment speeds on Fannie Mae mortgages neared 30 percent on an annualized basis, causing agency MBS spreads to spike. Prepayment rates following the August 2016 10-year Treasury yield lows have been contained at around 20 percent on an annualized basis, falling short of market fears.

Prepayment Speeds Defy Market Expectations

Source: eMBS, Bloomberg, Guggenheim Investments. Data as of 10.15.2016. 10-year U.S. Treasury yields in the chart are three-month averages as of the end of each month.

After strong returns in the first and second quarters, MBS had another positive total return of 0.6 percent in the third quarter of 2016. Spreads tightened 7 basis points to 99 basis points in the third quarter, while yields were roughly unchanged. Current yields of 2.1 percent are roughly 20 basis points higher than the lows in 2012.

We prefer a combination of TBA FNMA 30 years and moderate pay-up loan balance pools. Investors can take advantage of roll financing and liquidity in the TBA stack where the Fed is focusing most of its buying. Select loan balance pools priced no more than 1 point above their respective TBA coupons provide a good balance between carry and prepay protection. We would avoid most premium-priced LTV pools. Steady home price appreciation has eroded the protection initially afforded to these bonds. Many of the underlying borrowers can now refinance and lower their loan payment by eliminating the mortgage insurance fee assigned to the loan whose LTV originally exceeded 80 percent.

Agency MBS Spreads at Tight End of the Three-Year Range

Market relief over the contained pace of prepayment speeds, combined with positive investor sentiment as we near a potential Fed rate hike, has driven agency MBS spreads tighter. As of mid November, Agency MBS yields are roughly 100 basis points higher than seven-year U.S. Treasury yields.

Agency MBS Spreads at Tight End of the Three-Year Range

Source: Bloomberg, Guggenheim Investments. Data as of 10.15.2016.

—Jeffrey Traister, CFA, Managing Director; Aditya Agrawal, CFA, Vice President

Important Notices and Disclosures

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. ©2016, 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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