Some Mortgage Bond Investors See Opportunity in Market Sell-Off

(Bloomberg) -- For certain agency mortgage investors the quote attributed to the 18th century banker Baron Rothschild to “buy when there’s blood in the streets” brings the current environment to mind.

With the Federal Reserve announcing unlimited purchases of agency MBS and Treasuries on Monday, Treasury yields are likely to move lower while mortgage spreads tighten. The move has already begun in mortgages. The Fannie Mae 30-year current coupon spread over a blend of 5- and 10-year Treasuries, a popular valuation model, had tightened to 1.39% at Monday’s close from a recent high of 1.80% on March 19. It was at 0.90% at the end of last year.

There may be more room to tighten if history is our guide. The current coupon spread fell to a historic low of 0.55% on Sept. 25, 2012, a few weeks after the central bank announced a QE3 of $40 billion per month of agency MBS purchases and extended its “low rate” promise into mid-2015.

For context, this week the Federal Reserve is targeting $50 billion of agency MBS purchases per day. Once the over-indebted market players such as mortgage REITs are done selling agency MBS to raise cash, the full weight of Fed buying is likely to be felt.

A primary concern coming into the year was that net supply was expected to increase by 26% over 2019. This issue can now be put to bed, as with just $265 billion expected this year, the Fed’s rampant buying will leave little if anything for private investors. In addition, where the private market was also expected to need to absorb about $20 billion in monthly roll-off from the Fed’s mortgage balance sheet, that too has been removed from the supply/demand equation.

Mortgage supply due to home sales and refinancings are likely to drop dramatically into the summer due to social distancing, as face-to-face meetings between homeowners and prospective buyers come to a halt. In a report from March 20, Bank of America Corp. changed its supply forecast for the year to $2.6 trillion gross and $227 billion net, from $2.1 trillion and $283 billion, respectively, and noted that “technicals lean positive” for the sector.

Roll With It

All this Fed buying -- along with the Federal Housing Finance Agency authorizing Fannie Mae and Freddie Mac to enter into additional dollar roll transactions -- is a positive for the mortgage basis as they will boost dollar rolls. Dollar rolls will get additional support as prepayments are likely to drop over the near term, reducing that risk for the party that rolls in the collateral. In addition, slower prepayment speeds -- if TBA are trading at a premium -- boost those prices, and the entire conventional 30-year TBA coupon stack is trading well above par.

Dollar roll: A type of repurchase transaction in the mortgage pass-through securities market in which the buy-side counterparty of a “to-be-announced” (TBA) trade agrees to sell off the same TBA trade in the current month and to buy back the same trade in a future month

Another risk in dollar roll transactions is that of delivery, as the delivering side has an incentive to return to their counterparty what is termed the “worst-to-deliver” pools, those which exhibit the worst collateral characteristics, such as loan size, credit rating and servicer. Happily for mortgage investors, the central bank is notable for its habit of absorbing the worst-to-deliver pools, cleaning up the float for private investors.

Some mortgage investors have taken note that we are back in the world of QE, and that despite the recent selloff and spread widening, agency MBS look enticing. “The Fed has shown that it will support the agency MBS market. So it depends what investors’ goals and risk tolerances are but for a safe, liquid asset that you are buying at almost record spreads along side the entity with the largest bazooka in the world, MBS make a lot of sense,” John Kerschner, head of securitized products at Janus Henderson Group Plc., told Bloomberg News on Monday.

• 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

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