Agency Mortgage-Backed Securities: Prepayment Risks Rise as Mortgage Rates Drop
Prepayment risk for recently originated mortgages is high.
Agency MBS underperformed risk assets in the second quarter due to lower mortgage rates and a pickup in interest rate volatility. The Bloomberg Barclays U.S. MBS index posted a 2.0 percent total return for the quarter. Both option-adjusted and nominal spreads were wider over the quarter and are currently near the widest levels of the year.
The Mortgage Bankers Association Refinancing Index, a leading indicator of prepayment volumes, breached its first-quarter high as 30-year mortgage rates broke through and sustained sub-4 percent levels. While currently about 45 percent of 30-year mortgages are in the refinance zone, most of this prepayment risk remains concentrated in mortgages originated since 2018. This fast-paying subset of the mortgage universe, the rollout of single-security in June (a common single mortgage-backed security backed by issuance from both Fannie Mae and Freddie Mac), and the continued reduction in the Fed’s balance sheet holdings have all led to worsening performance of cheapest-to-deliver collateral and widening residential MBS valuations (RMBS). Conversely, less-negatively convex options, such as Agency multifamily bonds and better call-protected pools, have benefited. Looking ahead, the near-term technical picture remains challenging as supply picks up over the summer and incremental prepayment risk remains elevated. Despite these concerns, a dovish Fed and RMBS valuations near the widest levels of the year may provide a positive backdrop for the sector.
Prepayment Risk Rose as 30-Year Mortgage Rates Dipped Below 4 Percent
Mortgage Bankers Association Refinancing Index
The Mortgage Bankers Association Refinancing Index, a leading indicator of prepayment volumes, rose as 30-year mortgage rates broke through and sustained sub-4 percent levels.
Source: Guggenheim Investments, Bloomberg, Mortgage Bankers Association. Data as of 6.30.2019.
Mortgage Refinancing Risk Is Likely to Remain Elevated in the Near Term
The near-term technical picture remains challenging as supply picks up over the summer and incremental prepayment risk remains elevated. About 45 percent of 30-year mortgages are currently in the refinance zone.
Source: Guggenheim Investments, Credit Suisse. Data as of 6.28.2019. Assumes 50 basis-point rate incentive. Includes 15-year and 30-year MBS.
We continue to favor investments where either the collateral or structure offers some cash flow stability at reasonable spreads. Accordingly, we find select subsectors attractively priced in the current environment, including longer-maturity Agency multifamily, better call-protected pools, and some collateralized mortgage obligation structures. These investments have performed well, and we expect them to continue their performance in scenarios where interest rate volatility rises, interest rates decline sharply, or the Fed continues down the path of reducing its MBS holdings.
—Aditya Agrawal, CFA, Director; Louis Pacilio, 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, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management.
©2019, 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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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 Corporate Funding, LLC, Guggenheim Partners Europe Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.