The mortgage investment environment has changed significantly as a result of post-crisis financial reform, leading to increased market complexity and opportunities to add value through careful security selection. The $7 trillion¹ US Agency mortgage-backed security (MBS) market bears a number of unique investment characteristics due to its diverse buyer base, specialized trading mechanics, and strong liquidity. At IR+M, we focus on the opportunity set within specified pools to gain exposure to Agency MBS and believe we can navigate the nuanced market to provide a yield advantage with more stable and predictable cash flows.
Evolution of the Residential Mortgage Market
The Agency mortgage market is highly liquid and carries little credit risk. The greatest source of risk for Agency MBS is the timing of cash flows, as borrowers will prepay their loans at different rates or speeds based on fluctuations in prevailing mortgage rates.
Before the financial crisis, prepayment behavior was fairly predictable. Borrowers had few impediments to refinancing and behaved similarly. The overall interest rate environment generally dictated behavior, as prepayments tended to speed up when mortgage rates fell and slow down when rates increased.
As a result of post-crisis financial reform, the landscape of the Agency mortgage-backed sector has changed significantly. Outside a borrower’s willingness to refinance, a number of factors now impact their ability to refinance, including: credit availability, property valuations, loan balances, geography, and seasoning.
As a result, borrower behavior is less correlated to the interest rate environment and more difficult to predict. Agency MBS with comparable investment characteristics that once traded similarly are now behaving independently, as illustrated to the right.
Participants in the Residential Mortgage Market
The market value of the Agency MBS market totals nearly $7 trillion3, an amount rivaling the size of the Treasury market. The buyer base is large and diverse given the sector’s high quality and attractive yield relative to Treasuries. As a result of Quantitative Easing (QE), the largest individual holder of Agency MBS is the Federal Reserve (Fed), who will likely step away from the market as it begins normalizing monetary policy. Outside the Fed, there is a wide range of active participants, each with their own motivations for investing in the sector. For instance, banks have been major holders of MBS but prefer adjustable-rate and shorter-term mortgages. Pensions and mutual funds hold MBS to replicate mortgage-heavy bond indices, and are expected to change their allocations based on the sector’s share of the market. REITS are generally more focused on investment return, and tend to be marginal buyers when spread compensation looks attractive.
Channels for Investing in Agency MBS
- The majority of trading occurs in the “to-be-announced” or TBA market, where pools are identified after the trade
- The buyer and seller agree on six parameters: issuer, coupon, maturity, price, face value, and settlement date
- The delivered pools are typically the least attractive securities eligible for delivery
- The TBA market allows large managers to trade in significant size and quickly gain exposure
- Specified pools are securities in which details of the pool are known by both the buyer and the seller at the time of the trade
- The investor may be able to better predict future prepayments by analyzing pool characteristics and evaluating trends
- The specified pool market enables investors to avoid securities with less favorable convexity characteristics
IR+M focuses on the opportunity set within specified pools to gain exposure to Agency MBS. We believe some pools can have characteristics that provide a yield advantage without taking on greater interest rate sensitivity.
Liquidity of the Agency MBS Market
- Agency MBS are highly liquid as a result of the market’s government backing, large
buyer base, and TBA market
- Daily trading in the Agency MBS market surpasses both corporate and municipal markets combined, and volumes remained relatively robust throughout the crisis of 2008
- The added parameters of specified pools make them slightly less liquid versus the homogenous TBA market
- Specified pools are generally still eligible for delivery into TBA trades, which provides a backstop in the event that specified pools underperform TBAs
IR+M Themes + Conclusion
As a result of changes stemming from the financial crisis, the Agency MBS market has grown more complex. The renewed mortgage landscape, coupled with the other unique investment considerations, can drive inefficiencies and creates opportunities for security selection. At IR+M, we believe we can capitalize on these dislocations and invest using a bottom-up process focused on finding opportunities within the specified pool market.
1Barclays as of 4/30/15
2Bloomberg as of 4/30/15
3Federal Reserve as of 12/31/14.
4Sample IR+M Agency MBS Portfolio and Barclays as of 5/31/15. Data after 1/21/15 includes an adjustment factor to account for Barclays MBS prepayment model change.
5Sample IR+M Securitized Portfolio as of 5/31/15. There are limitations in sample results, including the fact that such results neither represent trading nor reflect the impact that economic market factors might have had on the management of the account if the adviser had been managing an actual client’s money. Actual results may differ. A similar analysis can be provided of any portfolio we manage.
6J.P. Morgan as of 5/28/15.
7Barclays and IR+M as of 4/30/15.
8Bloomberg as of 5/28/15
*Chart plots the Conditional Prepayment Rate (CPR) of Agency MBS pools versus Refinance Incentive (the difference between the pool’s gross WAC and prevailing interest rates)
The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.