By the Numbers
A fast market, a slower Fed drives rolls in lower coupons
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
With the average coupon in new 30-year MBS about to rise in March for the first time in more than a year, the Fed’s persistent appetite for lower coupons could keep lower coupon dollar rolls special for at least a few more months. It’s a story of the market and MBS production moving faster than the Fed’s process for retargeting coupons.
The average coupon for a newly issued 30-year mortgage backed security is poised to increase in March for the first time since February 2020. The increase is small, but reflects a 15% drop in production of 2%s and a nearly 50% increase in production of 2.5%s. However, Fed MBS purchases trended towards lower coupons in February and March, opening up a gap compared to the average coupon produced. Throughout most of the pandemic the Fed was buying pools at a coupon slightly higher than production, but now the Fed’s purchases are skewed to a lower coupon than production. This has likely contributed to special financing in the 1.5% and 2% dollar rolls and should support special financing for the upcoming months.
The Fed primarily wants to provide liquidity for the production coupon, which helps mortgage originators. The spread between the average production coupon and the average coupon bought by the Fed in a given month has typically been small (Exhibit 1). However, early in the pandemic the Fed also bought higher coupons to provide additional support of the MBS market, so the Fed coupon was substantially higher. From July through October the Fed was buying slightly higher than the average production coupon.
Exhibit 1: Fed buying in 2021 has been overweight lower coupons
Note: Data shows the average coupon issued each month is compared to the average coupon acquired by the Fed in settled trades.
Source: Federal Reserve Bank of New York, Amherst Pierpont Securities
But in November and December 2020 the coupon spread collapsed, and in 2021 the average Fed coupon fell below the average production coupon. This coincides with the Fed’s decision to start buying 1.5%s. In February and March the Fed bought more than 40% of all 1.5%s issued, a level of support not given to a production coupon since the first months of the pandemic. On the other hand, in March they bought only 18% of new 2.5% pools, perhaps unable to adjust rapidly enough to the sharp increase in MBS yields in February.
Exhibit 2: Fed takeout of monthly 30-year UMBS issuance by coupon
Note: Data shows the percentage of monthly issuance in each coupon purchased by the Fed.
Source: Federal Reserve Bank of New York, Amherst Pierpont Securities
Looking ahead, the Fed’s current schedule of TBA trades shows them shifting volume from 1.5%s into 2.5%s over the next two months (Exhibit 3). The top half of the exhibit shows the distribution of monthly production by coupon from January through March, and the bottom half shows Fed purchases that settled in March and are currently scheduled to settle in April and May.
Exhibit 3: Monthly distribution of issuance and Fed purchases by coupon
Source: Federal Reserve Bank of New York, Amherst Pierpont Securities
Comparing the March numbers shows the mismatch between production and Fed buying. Only 16% of new pools were 1.5%s, but the Fed allocated 25% of their buying into that coupon. They were slightly overweight in 2%s as well, resulting in a low allocation in 2.5%s. Their forward schedule appears to maintain the overweight in 2%s, while they shift out of 1.5%s and into 2.5%s. That would bring their buying of 2.5%s in-line with March, but pool issuance may move even higher.
The Fed’s heavy support of lower coupons has likely been a large contributor to special financing in lower coupon dollar rolls. It appears likely that these rolls will continue to benefit from heavy Fed buying over the next couple of months, as they may not be able to shift their buying up in coupon fast enough to respond to changes in supply. It is possible that the Fed uses recent production to guide buying over the upcoming month, which would cause them to lag changes in production when interest rates move.
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