Mortgage Traders Breathe Easier as the Risk of a Refinancing Wave Ebbs

(Bloomberg) -- Mortgage investors are breathing a sigh of relief amid signs a potential surge in prepayments set to weigh on returns may be avoided.

An 11 basis point uptick in mortgage rates since the end of March has seen the Mortgage Bankers Association’s U.S. Refinancing Index tumble about 28 percent in three weeks. It’s the steepest aggregate decline in the index over a similar period since February 2015.

As 30-year mortgage rates dropped to as low as 4.06 percent in March from 4.94 percent in November, investors girded themselves for a wave of refinancings by bidding up specified pools and receiving fixed payments via swaps to add duration. The MBA gauge, a measure of refinancing applications, more than doubled in that span, reaching its highest since 2016. Prepayments can hurt investors that paid more than 100 cents on the dollar for mortgage bonds, as they get their principal back sooner than expected and at par, cutting into returns.

Mortgage Traders Breathe Easier as the Risk of a Refinancing Wave Ebbs

Specified Pools Explained

One way for mortgage-backed security investors to protect themselves from a surge in prepayments is through purchasing specified pools -- bonds created using borrower characteristics such as credit scores or loan size -- designed to provide more certainty on when the underlying mortgages will be paid off

High credit scores and large loan sizes have been showing up in the current 30-year conventional mortgage production coupons, the premium-priced 4 and 4.5 percents. Those are refinancing red flags, and sent investors in search of ways to reduce their risk, for example by buying low loan balance specified pools.

As of the end of March, the year-to-date rally seen in low loan balance specified pools for 30-year 4 and 4.5 percent coupons, which historically have seen relatively slower prepayments, was 24/32 and 1-5/32, respectively, according data compiled by Bloomberg. In April the 4 percent pool has increased 11/32 while the 4.5 percent is unchanged.

About $400 billion of mortgages no longer have enough incentive to refinance due to the recent move higher in rates, according to Scott Buchta, head of fixed income strategy at Brean Capital.

“At this point, we expect prepayment speeds in conventionals to peak in May and begin slowing down precipitously in June, especially in the cuspy 4 and 4.5 percent coupons,” Buchta wrote in a note to clients Wednesday.

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