US MBS falls apart mid-month

• Sluggish out of the gates.
• Negative on the negative convexity.
• Supply glimpse offers insight into prepays

In a puzzling open for MBS, especially after the robust close out to 2023, spreads widened as prices dropped and traders once again debated the debatable-timing and direction of forward Fed rates moves.   

Economic data has been strong the past quarter plus and the necessity to lower rates has paused, at least psychologically. That spells trouble for MBS products, especially the bulk of the MBS Agency index with the majority of the outstanding coupon population sporting 20-to-25-point discounts to par ($100), yielding flat to positively convex profiles-those that fall in sympathy to falling Treasury prices and no peel off (convex) movements when things really tumble. Classic MBS is negatively convex, where the performance increases as rates rise (lessened prepay assumptions) and performance wanes as rates rally (increased prepay assumptions). The deeply discounted coupon stack reverses that outcome as the interest component of MBS decreases that far away from par.

MBS index performance for January limped to an all-around -48 basis points in Total Return (MTD), with excess returns to duration neutral Treasury index -39bps. The 10yr yields rallied toward the latter part of January, closing at 3.94% (flat on the month), while the slope of the 2s10s yield curve did “steepen” 10 basis points to a less inverted -28.9 bps. Closely followed 3m10y Vols (normalized) dropped another 9bps to +105 as event risk seemed taken in stride even as the world deals with two wars globally but few domestic economic tumults.

Originator supply is about as much of a factor as prepayments, and yes, they do coincide with each other by nature. Daily origination supply (as reflected in TBA hedging) spiked to $2.2 billion per session (+7% MoM), with locks (pull throughs) being opportunistic whenever rates backed up. The pipeline continues to be dominated by 5%s through 6.5s%s at 93% of the net coupon locking, while7%s and 7.5%s have tailed off recently (3%). The 30yr FHLMC primary rate rose modestly to 6.69%, up 7 basis points from the start of the month/year. Lastly, Bankrate’s daily quote is starting to settle in below 7%, after the groundbreaking moves above 8% late last year.

The plight of Originators and loan producers is quite well know,,, but we thought we’d recite it again anyway!

Most of the MBS Agency Issuance (90-95% of all MBS production) is inversely tied to interest rates. As rates rise and mortgage interest costs climb, production lowers. Additionally, borrowers with mortgages set below prevailing rates and little incentive to refinance unless they are in dire need of cash to meet c current expenses.

From the first chart, one can see the peak of production (since 2015), was 2021 as rates were forced lower by Federal Reserve actions. In the years since, rates have arched higher, the Fed has receded or ceased open market MBS buying ops, and borrowers have stood pat on their mortgages.

For 2024 so far, the total is $68.5 billion, on another sub $1Trillion pace but not a straight-line average as home buying season has yet to kick in. Of that total, the breakdown is quite interesting, especially to mortgage lenders seeking refinance candidates. From the next chart, the bulk of issuance (50bp net coupons) is clustered around 6.5s and 6s, with underlying note rates between 6.83% and 7.32%. This is of most use to lenders, seeking a refinancing candidate if rates keep lower into 2024.

The final dive we are taking directly has a bearing on refinancing, with pool story or loan type delineating refinanceability. The specified story of the bond (Spec pool) identifies predominant loan amount, borrower profile, geographic concentration that heavily influences the ability and desire to prepay or refinance.

From the chart, which focuses on January production of higher net coupon (6s through 7.5s) we can see that there is a principal amount of generic and not especially prepay protected pools tallying $27.6 billon or roughly 40% of production this month. Naturally the seasoning ramp of pools extends out farther to be considered ready to refinance but we thought we’d show you an example for arguments sake as the months roll off into 2024.

MBS issuance is a long way off from its “salad days” of 2020 and 2021 when the Fed sparked the most recent refinance wave. Presently, they are removed from the market, not adding and letting the portfolio run off via prepayments and possible inclined to future portfolio sales (not likely). Treasury rates moves will now control the setting, with little to no official MBS assistance.

However, Originators and Services still have to keep the lights on, and the plethora of higher coupon/loans have a generic concentration and are prime candidates for lender calls to refinance.

Let’s see how this next rate cycle plays out.

Things started to go south for Mortgages at about the halfway point of the month, before recovering late as February beckoned. 4% was the key inflection point along the 10yr note, and ruled performance as sell offs above that mark soured investor moods, while rallies stemmed the tide. No one wants to catch the proverbial “falling dagger” generally, and weakness seemed to beget weakness in spreads. The 30yr current coupon rose 25 basis points at mid-month, coinciding with the rates backup, before firming about the same as treasuries rallied into the close.  

The 30yr current coupon (30yr CC) was net higher just 7 basis points to 5.33%, OAS wider 5bps (31), ZV firming 4 bps (123), while the 5&10yr Treasury comparison was flat to 140.     

In the span of 12 months’ time, January 2023 to January 2024, MBS has had quote a ride wholly reflective of the economic backdrop replete with Fed moves, Bank collapses and global turmoil. All the while, the market has proved somewhat resilient with a modest lag to recovery provided the rates direction was to its liking.  

The spikes higher and wider on the chart below pinpoint two events; SVB/Signature banks in May where modest panic ensured, and then late October where rates were cresting at their recent highs and almost the entire MBS coupon stack was trading at a discount. Once the FDIC auctions were completed and the Fed indicated it was done with rates hikes, things dramatically rebounded.