Mortgage Investors Brace for Coming Wave of Loan Refinancings

(Bloomberg) -- With the 30-year mortgage rate just 14 basis points above its all-time low of 3.31% seen in November 2012, mortgage-backed security investors are bracing themselves for a wave of refinancings in the coming months.

The prevailing sentiment for higher prepayments ahead is shown by a Bloomberg Barclays U.S. MBS index duration that is just 2.62 years, down from 4.71 one year ago and approaching the trailing-one year low of 2.34 seen on Sept. 4, according to data compiled by Bloomberg.

Duration -- a measure of a security’s price sensitivity to a change in interest rates -- will drop on the belief that principal payments on that bond will be received earlier than previously expected. That’s what occurs with mortgage-backed securities as rates decline.

When that happens the expectation is that more homeowners will refinance into lower mortgage rates and pay off their previous loans. And with the entire 30-year conventional MBS coupon stack trading at a premium, this can hurt performance.

The January prepayment report saw aggregate conventional 30-year speeds drop 13% month-over-month, and February is expected to see a rise of about 8%. However, it’s the March report that has investors positioning their portfolios for higher refinancings. Wells Fargo MBS analysts point to that month’s importance -- with seasonals, day count and the refinance index all rising -- and warn they could “come together to make for the perfect prepay storm.”

With the drop in mortgage rates, about 60% of conventional (Fannie Mae and Freddie Mac) and 70% of government (FHA and VA) home owners have at least 0.50% of incentive to refinance, according to a recent note by Scott Buchta, head of fixed income strategy at Brean Capital. Just two months ago it was 40% and 50%, respectively, of homeowners who had that incentive.

For investors it’s important to drill down by coupon to see which securities may or may not have an incentive to refinance. For instance, 30-year Fannie Mae 2.5% of 2019 and 2018 vintage have weighted-average coupons of about 3.50%, too close to the prevailing 3.45% mortgage rate to make refinancing attractive. In response, investors have bid the Fannie Mae 2.5% TBA price up above par since Jan. 23 in order to add both duration and prepayment protection to their holdings.

Another popular means to prepare a portfolio is through purchasing specified pools designed to protect against higher speeds, such as those made up of seasoned or low-loan balance mortgages, both of which tend to exhibit slower than average prepayments. Oppenheimer’s Head of Agency MBS Research Richard Estabrook wrote Feb. 6 that specified pool trading surged in January to its highest month since at least mid-2011.

• Christopher Maloney is a market strategist and former portfolio manager who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Christopher Maloney in New York at cmaloney16@bloomberg.net

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Adam Cataldo, Dawn McCarty

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