"Risk Off": MBS Buyers Missing in Action

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The benchmark 10-year note finished the day +14/32 at 101-23 yielding 2.926% (-4.9bps) and the 2s/10s yield curve bull flattened another 5 basis points to 255 wide. Bonds managed to squeeze out these gains despite more scratching and clawing from stocks, which continue to hover around key technical support at 1270.  The SP went out  +0.17% at 1267.63.

Stocks are clinging for life here, entrenched weakness is obvious and bonds aren’t being fooled. That is why bonds were better even though stocks rallied. Profit taking was however noted in Treasuries as fast money types aren’t leaving chips on the table for long without a confirmed downturn in stocks. Lots of anxious market watchers out there….there’s a weird feeling in the air ahead of Quadruple Witching day tomorrow. WHY IS 1270 IMPORTANT IN SPs

The flight to safety that poured into benchmark Treasuries was no where to be seen in mortgages though. MBS prices did rally today but only because of the friendly directional guidance offered by Treasuries.  TBAs were actually “bid wanted” across the coupon stack, again. Buyers are no where to be found! That is obvious when comparing today’sMBS price appreciations to those of Treasuries. The 10yr note finished the session +14/32 while the Fannie Mae 4.0 MBS coupon went out +1/32. When adjusting for duration differences (65% hedge ratio), FNCL 4.0s were outperformed to the tune of 8/32. That follows a 12/32 lag yesterday. I’ve got the secondary market current coupon marked at 3.899%. That’s 97bps/10yr note and 82bps/10yrSwaps (which got destroyed today as well). Those are the widest yield spread levels since early December 2010. That means MBS haven’t been this cheap in 6-months! Yet buyers just don’t seem to care….

WHAT GIVES?

“Risk-Off” is what gives.

When mortgage rates are expected to move lower in the future, well I should say low
enough to provide incentive to refinance, the pools of
mortgages (MBS) that are backed by loans with higher rates begin to
lose more and more value as rates go lower and more borrowers refinance
their loans (they prepay their loan or use their call option). Remember
the income MBS investors expect to receive is generated when borrowers pay
their monthly payment, so if you refinance your loan MBS investors lose
the income stream they were expecting you to contribute to the MBS pool they owned.
MBS investors therefore must find a way to replace that lost  cash flow.  This can result in either buying “down in
coupon” (when yield curve flattens) or “up in coupon” (yield curve
steeper). Often times when selling a pool of MBS made up of mortgages
with higher interest rates, investors will look to buy pools secured by
loans with lower rates to stabilize their expected future cash flows.
This is called a “down in coupon” day and is a major force in the daily
price movements of mortgage backed securities. The same happens on “up in
coupon” days but in that case MBS investors sell “rate sheet
influential” MBS coupons and mortgage rates generally move higher.

Plain and Simple: Stocks are teetering on a capitulative event
that would lead bond yields even lower and MBS prices even higher. That
would be a positive for mortgage rates and fence-sitters who missed the
boat in early November. If a scenario like this were to play out and
mortgage rates revisited all-time lows, a mini-refi boom would be upon
us. That makes MBS highly “callable”. Not something MBS bond investors
are excited about! Buying mortgages now, when prices are over par,
leaves the investment  vulnerable to prepayment risk. Paying a premium
to buy mortgages only to have that principal investment returned at par
is not a winning strategy!  

The thing is….we’re not seeing the shift “down in coupon” we’d normally see in a falling mortgage rate environment. (Avoid acronyms).

WHY?

Loan originators know the answer to that question better than anyone else…because borrowers aren’t refinancing! Whether it be tight credit, falling home prices, or limited benefit, refinance demand just isn’t keeping up with falling mortgage rates as it should.

But the threat of a mini-refi boom is constantly looming. It just isn’t worth the prepay risk with a stock sell-off driven dip in mortgage rates potentially already in progress.   So with quarter end fast approaching and Fannie 5.5s bid in the uber-expensive 108 price handle, the rinse and repeat “up in coupon” trade that has thrived for well over a year now has been deemed off-limits. And the shift “down in coupon” has been put on hold until another mini-boom forces MBS investors to extend the duration of their loan portfolios. Volatility is back. Why risk it now when prices are moving all over the place? It’s better to let MBS cheapen and buy later when convexity is no longer implied by models and it’s seen on the street via a huge uptick in loan production.

We’ll rely on loan originators to tell us when business picks up. And we’ll be sure to pass the message along to prepay forecasters.  

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