Low interest rates have been a boon to consumers, who are buying new homes and refinancing existing ones at record-low rates—but investors in mortgage-backed securities (MBS) haven’t been so fortunate. Here is how we seek to avoid the perils of today’s low rates.
How We Got Here
At the beginning of 2019, when the target federal funds rate was 2.25% to 2.50%, the U.S. fixed-income markets were still trying to digest the effect of the four rate hikes in 2018, and the projections of more rate hikes in 2019 as the Federal Reserve (Fed) communicated a target rate of 3% by the end of the year.
Fed trackers were also curious to see what might be the impact of a new vice chair of the Federal Reserve Board of Governors, Dr. Richard H. Clarida, who was appointed to a four-year term on September 17, 2018. He appeared to be less confident in the Fed’s capacity to support a continued expansion.
At the July 31, 2019, Federal Open Market Committee (FOMC) meeting, rather than raising rates again, the Fed reduced the target federal funds rate a quarter of a percentage point, stating that the data showed that economic growth was beginning to slow. Then the Fed cut rates two more times to end the year at 1.50% to 1.75%. This was a significant change in market sentiment.
Some market participants consider the three cuts to be a midcycle adjustment, likening it to the phase of the cycle that occurred in the1995 and 1998 economic expansion, in which the Fed helped facilitate a continued expansion.
With the target federal funds rate currently at 1.50% to 1.75%, federal funds futures markets are pricing in another rate cut in the summer of 2020.
Is 100% of the MBS market in the money to refinance into lower rates? We don’t think so, and believe we can continue to generate an income advantage over passive MBS strategies.
The decline in the federal funds rate has led to lower interest rates on new and refinanced mortgages. That’s great for consumers, and they’re taking advantage of the boon. The Mortgage Bankers Association’s weekly indicies show that applications to refinance an existing mortgage are up sharply this year and applications to purchase a home are strong and steady.
The decline in the federal funds rate is great for consumers, but MBS investors aren’t quite as thrilled.
MBS investors arent’t quite as thrilled, because they face two primary risks: prepayment risk (getting your money back rapidly and being forced to reinvest at lower rates) and extension risk (earning below-market income for a longer period than expected).
To illustrate, consider a relatively new MBS: a 30-year fixed-rate 4% U.S. agency mortgage-backed security issued in January 2019. (Such securities make up more than 20% of the Bloomberg Barclays U.S. MBS Index, which means passive money managers will have to employ this security, or those like it, to track market exposure.)
This freshly minted security was originally issued in the size of $7.4 billion of unpaid mortgage balances, but those balances have been prepaid down rapidly to $4.2 billion in less than a year as homeowners refinance their mortgages at lower rates.
Clearly, this puts MBS investors at a disadvantage, as principal is returned faster than expected, and those proceeds will be reinvested at much lower rates, effectively reducing yield and total return. This leads one to ask: Is the entire MBS market eligible to be refinanced?
Moreover, the effect of these refinancings is the creation of net new supply of MBS. We believe that net new supply will range from $220 billion to $300 billion in 2020, and the fixed-rate coupons will range from 2% to 3%. This significantly increases the interest-rate risk and market-value volatility of approximately 80% of the MBS market.
We mitigate prepayment risk by employing U.S. agency-specified pools that are composed of mortgage loans from borrowers that have small balances.
In 2020, we expect the Fed to be data-dependent, with its actions dictated by the health of the U.S. economy. In their own words, policymakers will “act as appropriate to sustain the expansion.” With that in mind, as of this writing there appears to be no chance of interest-rate hikes this year.
While we do not try to time interest rates, we believe that our above-market coupon strategy, employed in the MBS sector, will continue to boost returns due to solid monthly income generation. Another advantage of investing in high-coupon MBS is the principal value stability it provides in a volatile interest-rate environment.
We mitigate prepayment risk by employing U.S. agency-specified pools that are composed of mortgage loans from borrowers that have taken out small balances to purchase their homes. We believe that targeting low loan balances is an effective strategy because a borrower may decide that the savings on the monthly mortgage payments at a lower rate may not be enough to justify the expense to refinance.
Focusing on this segment of the MBS market gives us the ability to generate higher levels of income over passive MBS strategies. This provides us with a potential income advantage for a longer period, and thereby the potential to generate attractive returns.
Paul Sularz is a portfolio manager on William Blair’s Fixed Income team.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Prepayment of mortgage-backed securities during periods of declining interest rates may reduce returns. Slower prepayments during periods of rising interest rates may increase the duration of mortgage-backed securities and reduce their value.