US Mortgage-Backed Securities – Don’t Fear the Cone

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After last week’s meeting Federal Open Markets Committee of the FedChairman Jay Powell made it clear that the committee is talking about a $ 1 billion cut in its asset purchase program. We await more details on the timing and scope of the contraction at upcoming FOMC meetings.

Many expected the Fed to begin cutting in late 2021 or early 2022. Thus, Chairman Powell’s comment was not supposed to be market-influencing news. However, premiums on mortgage-backed securities (MBS spreads; see Exhibit 1) increased and the asset class lagged.

Should MBS Investors Be Wary of Narrowing?

The good news for MBS investors is that recent prepayment reports are finally showing signs of slowing due to higher lending rates and the fact that economically stimulated borrowers have already refinanced their loans.

The average price of the MBS Index in US dollars is 104.48, which is still well above par. Thus, slower prepayments should improve the portability of the MBS asset class.

As the Fed approaches a cut, we expect US interest rates to rise, leading to higher mortgage lending rates. This should slow down refinancing activities, which in turn should lead to a reduction in the initial supply. We think this will help reduce MBS spreads.

For a 12-month scenario analysis of the range of interest rates and economic conditions, we assumed that the base case is no rate change. This should allow our strategy to earn 3.41% with an MBS Index return of 1.62%.

If rates rise by 25 bps, the strategy’s yield will still be 2.71%, and it could outperform the index by 180 bps. Thus, even in conditions of growing rates, rates are expected from a strategy with strong positive absolute and relative returns.

There is no end to reflationary trading.

In response to recent changes in monetary policy, the market has been closely monitoring the Fed’s response to rising inflationary pressures. The central bank cited the recent rise in inflation primarily as a function of the annual baseline effect when comparing current prices to last year’s lows during the lockdown. The reopening of the economy has also created mostly temporary bottlenecks and disruptions in the supply chain.

The FOMC meeting last week, however, was more hawkish than expected, as Chairman Powell noted that inflation could turn out to be “higher and more resilient” than expected. It is noteworthy that some Fed members have put forward their forecasts for future rate hikes, and some now see the first step in late 2022. Powell acknowledged that the FOMC is actively discussing cutting bond buying programs.

After the FOMC meeting, global stock markets fell, the yield on 10-year US Treasuries rose, and the MBS sector performed the worst. In our opinion, the unusual smoothing of the curve observed after the more aggressive Fed meeting was caused more by technical conditions than by market fundamentals.

While commodity prices have indeed gone up, they are still skyrocketing from pre-pandemic levels. Growth prospects in the US are improving and the labor market is making significant headway. At this point it seems premature to call the end reflation trade.

Slightly higher and slightly steeper

The United States has made great strides in the fight against the virus, with over 60% of the adult population now vaccinated. The economy is opening up and gaining strength. The Fed is on the right track to lift emergency and emergency measures.

The first step we expect to take in late 2021 or early 2022 is to scale back the massive asset purchase program. Talk of a cut continues, but we expect a long runway with clear information from the Fed about the actual start of the cut. Against this backdrop, we expect US yields to rise slightly and the yield curve to become a little steeper.

With rates rising, the MBS asset class tends to outperform other fixed income asset classes due to its shorter duration and the benefits of slower prepayments and less supply.

Unlike corporate or treasury bonds, MBS amortizes assets with monthly cash flow. Investors receive interest payments every month, as well as planned and unscheduled payments of the principal amount of the debt. These frequent intermediate cash flows give MBS investors the ability to continually reinvest capital as rates rise. This is the main difference from corporate or treasury bonds.

MBS – sector with long-term positive outlook

Although the current nominal spreads on the current MBS coupon are around 90bp, we are neutral as we await further information from the Fed regarding the narrowing. We tend to outweigh MBS in the event of market volatility due to the Fed’s emission cuts news. We have a long-term positive outlook on the sector.

We expect that as the Fed tightens and begins to roll back emergency measures, rates will rise and prepayments will slow down even more. We’ve already seen evidence of this. In May, lenders reported that demand for refinancing had dropped significantly for all types of loans.

This is consistent with other data that we see. The Morgan Stanley Truly Refinanceable Index, which represents the percentage of borrowers with at least 25 basis points of incentive to refinance, is now 50%, up from peaks of 80-90% in the second half of 2020 (see Exhibit 2). Slower prepayments mean better portability and less refinancing offer.

Contrary to concerns about shrinking, this will be the build environment for the MBS asset class.


Any points of view expressed here belong to the author as of the date of publication, are based on available information and are subject to change without notice. Individual portfolio management teams may have different views and may make different investment decisions for different clients. The opinions expressed in this podcast are in no way investment advice.

The value of investments and the income they receive can both decrease and increase, and it is possible that investors will not recoup their initial costs. Past performance is not a guarantee of future earnings.

Investments in emerging markets, specialized or limited sectors are likely to be subject to above average volatility due to high concentration, greater uncertainty, because less information is available, there is less liquidity, or because of greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than most international developed markets. For this reason, portfolio trading, liquidation and conservation services on behalf of funds invested in emerging markets may carry a greater risk.


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