Agency Mortgage-Backed Securities: No Need to Fear Refi Wave
Demand remains strong as Agency MBS is one of few positive-yielding, high-quality asset classes.
The liquidity and spread advantage of Agency MBS has made the sector an attractive place to invest, even in the face of increasing prepayment speeds. As foreign central bank policies continue to drive down global interest rates, demand remains strong as Agency MBS is one of just a few positive-yielding, high-quality asset classes. Agency MBS returns are especially strong after adjusting for both funding and currency hedging costs. Spreads may come under pressure as supply is likely to increase as mortgage rates fall, yet this concern is being offset by continued Fed sponsorship. With benchmark yields hitting historic lows, there are concerns that the Agency MBS market will experience a refinancing wave similar to 2012, when the refi index was over 3,000 points higher than today. Risks are rising, yet we foresee that it will take a further drop in rates to ignite the same reaction. While the current rate available to borrowers is virtually identical, today’s average outstanding borrower rate and the subsequent refinancing incentive are much lower. In order to match past refinancing waves, mortgage rates will need to drop another 50 basis points.
Agency MBS Spreads Remain Range-Bound Despite Widespread Volatility
Agency MBS spreads will come under pressure as supply is likely to increase as mortgage rates fall, yet this concern is being offset by continued Fed sponsorship and strong foreign demand. Agency MBS spreads have remained in a tight 25 basis-point range since the beginning of 2015. The experience of the past 18 months has demonstrated the resilience of the Agency MBS asset class.
Source: Bloomberg, Guggenheim Investments. Data as of 7.22.2016.
Agency MBS gained 3.1 percent on a total return basis in the second quarter of 2016 based on the subcomponent of the Barclays U.S. Aggregate index, with spreads to Treasurys remaining relatively flat at 106 basis points over the quarter. Agency MBS yields declined further along with Treasurys during the quarter, from 2.35 percent to 2.07 percent by the end of June 2016.
The loan balance pools we highlighted last quarter have appreciated significantly and we now prefer current production 30-year FNMA 3 percent coupons. Portfolios can also add convexity with moderate pay ups in selective 3 percent coupon loan balance and high loan-to-value pools. We would avoid most 3.5 percent coupon securities originated in 2014 and 2015—these are likely to see a substantial prepayment speed pickup in the coming months, as this is their first exposure to lower-rate incentives. Some of the more seasoned vintages, which have already had multiple opportunities to refinance, are still attractive.
Despite Similar Mortgage Rates, Refinancing Incentives Are Much Lower Today
In the second half of 2012, the MBA U.S. Refinancing index, which measures refinancing activity, reached 5,888. Despite Treasury rates setting record lows in 2016, the index reached 2,869, but has since declined. The lower level of refinancing activity is explained by the lower refinance incentive—the difference between the rate on the average outstanding 30-year mortgage and the primary rate. Because the average outstanding 30-year mortgage rate is only 4.4 percent, there is much less incentive for borrowers to refinance.
Source: J.P. Morgan, Guggenheim Investments. Data as of 6.30.2016. *Average outstanding 30-year mortgage rate minus primary mortgage rate.
—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, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.
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Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.