Agency MBS is my warm, fuzzy place. Amidst market chaos, it makes sense to me when little else does. Take March for example. When bid-side liquidity dried up, we could still sell our Agency MBS pools to the Federal Reserve (Fed). When credit fundamentals were a big question mark, we could still quantify the impact of prepayments on cashflows. When fixed income pricing was largely opaque, we could still rely on the transparency of TBA (To-Be-Announced) bid-ask spreads. It was not fun – Agency MBS returns took it on the chin – but at least the future outcomes were quantifiable. If you find solace in hard data, MBS will not let you down.
The Agency MBS market has seen it all over the past 20 years. The early oughts’ ushered in a new era of liquidity – the result of a hot housing market, expanding GSE footprint, and generational lows in interest rates. In June of 2003, the Lehman MBS Index duration fell below 0.5 years (still the low watermark) before sharply extending six-fold in subsequent months. Meanwhile, both Fannie and Freddie shifted their affordability programs into high gear. Not only did they ease lending standards by reducing their guarantee fees, but they also backstopped the secondary market with trillion+ dollar retained portfolios (the original QE!). This stoked hyper-liquid mortgage credit conditions, which allowed borrowers of all types to refinance at any time with little effort. Prepayment rates became sensitive to even small changes in interest rates. Many investors began employing interest rate forecasts to form their opinions on MBS valuations.
Then the Great Financial Crisis (GFC) hit. Housing cratered, and mortgage affordability dried up. The GSE’s were placed into conservatorship, forcing the liquidation of their retained portfolios and the stratification of their credit wrap pricing. The once blazing refinance machine was suddenly loaded with frictions. Prepayments slowed in an uneven manner, which then spawned underpriced opportunities in prepayment-protected pools across the multi-trillion-dollar universe. Agency MBS was reborn as a bottom-up bond picker’s paradise.
But there were bumps in the road. In 2011, the federal government attempted to re-ignite refinance activity via their Home Affordability Refinance Program (HARP). But volumes never lived up to expectations. In May of 2013, the Taper Tantrum further dampened refinancing activity, and the Barclays MBS Index Duration extended to almost six years (a 20-year high). Specified pool price pay-ups on niche stories, from servicer type to high-LTV (loan-to-value) to credit-impaired borrowers, continued to rise as more investors sought shelter from rising prepayments. All the while, the Fed waxed and waned on its MBS-QE program. Top-down investors were on the edge of their seats.
Then the global pandemic hit. What was forecasted to be a mild year for interest rate volatility exploded into a major convexity event. Those top-down investors who held over-weights in lower coupon MBS pools were stung by the sudden contraction in cashflows. Case in point: the duration on a generic 3.0% 30-year Agency MBS declined from around four years in January to approximately 1.5 years last month. Shedding that much interest rate sensitivity amidst a 140bp rally in intermediate Treasuries cost holders roughly 3.5 points (1.40 points * 2.5 years). A negative convexity hit of that magnitude could wipe out years of carry.
So how does an Agency MBS investor avoid that type of shock? A mortgage can be thought of as a fixed coupon bond plus a written call option to the borrower. If the borrower chooses to prepay for any reason (refinance, extract home equity, sell the property), the option is exercised. The remaining principal is then promptly returned to the investor at par. Ditto if the borrower defaults – the agency credit wrap covers the prompt return of principal. The trick is to predict when borrowers are inclined to take action away from paying their monthly bill. It’s a numbers game. A typical MBS pool has hundreds, if not thousands, of borrowers, and some will be quick to refinance while others will not. Layer on top of that, a handful of borrowers will move or default regardless of interest rates. Ironically, the more creditworthy the borrower, the higher the prepayment sensitivity to changes in interest rates. But bottom-up investors stay far away from making those interest rate projections. As Aristotle wrote in Ethics, “it is the mark of an educated man to look for precision in each class of things just so far as the nature of the subject admits.” You can’t stop prepayments from rising, but you can mitigate their impact on price.
The key is to estimate the shift in borrower behavior relative to the change in interest rates. This requires significant quantitative analysis on a pool-by-pool basis. This process culminates with the assignment of a duration that balances the risk to returns of faster prepayments with that of slower prepayments. We also compare the market price for the pool’s flavor of prepayment protection to the available alternatives. This relative value is conducted absent forecasts on interest rates or the economy. As the saying goes, there are no bad bonds, only bad prices. We would add that there are also bad durations.
So, what’s the outlook now? Even with the Fed setting the target rate at zero for the foreseeable future and purchasing up to $40 billion/month in MBS as part of QE-4, the risks remain twofold. Rising competition in mortgage lending may lead to even lower rates (faster prepayments). A faster-than-expected economic recovery or Fed pivot could lead to higher rates (slower prepayments). Finding reasonably priced prepayment-mitigating pools remains critical. It takes patience to shift through hundreds of offerings and pages of analytics, but that is where we find comfort as bottom-up Agency MBS investors. Ah, that warm, fuzzy place.
