The IO market steps back to reset

Brian Landy, CFA | July 23, 2021

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.

Demand for MBS that pay interest only has slowed recently as investors wrestle with a series of surprises. Prepayments have exceeded expectations through much of the pandemic, tagging IO prices along the way as market expectations and prepayment models reset to faster speeds. Prepayment risk has increased in July as rates fell and volatility picked up. Investors also have recent and potential policy changes to worry about that could lift prepayment speeds further. The combination of these factors has pushed many investors to the sidelines. But despair not. Fed tapering could change a lot of things.

A testy model

Mortgage prepayment models generally failed to capture fast prepayment speeds throughout the pandemic. Mortgage rates fell to historic lows and prepayment speeds reached levels last achieved prior to the 2008 financial crisis. Most mortgage IO investors use the Yield Book prepayment model, which also struggled to predict fast prepayment speeds despite an update in December. Over the last few months Yield Book has put out new trial versions of the model, and each iteration typically produced faster prepayment speeds.

The succession of model changes pushed IO valuations lower and has made many investors wary of buying IOs before Yield Book settles on a final version. The IO market reacts strongly to Yield Book changes since many investors rely on it to mark their books. When the model forecast increases, investors will generally hold the option-adjusted spread constant and mark their positions at a lower price. Even investors with their own prepayment model and potentially a different view of prepayment risk than Yield Book will need to mark to the market price, which is driven by Yield Book’s model.

Lower rates, higher volatility in July

Lower mortgage rates in July have come along and increased prepayment risk and reduce demand for IOs. Mortgage rates increased from January through March 2021 but dropped quickly in the first half of April. They remained steady until late June, before falling throughout most of July. Mortgage rates have fallen 40 bp since the 2021 peak according to Freddie Mac’s Primary Mortgage Market Survey (PMMS) rate and are only 13 bp higher than the survey low set on January 7. And investors that delta-hedged their positions took losses since they were unable to adjust their hedges fast enough as rates fell and may be unwilling to put more money into IOs.

Exhibit 1. Mortgage rates dropped in April and July

Freddie Mac’s Primary Mortgage Market Survey rate.
Source: Freddie Mac, Bloomberg, Amherst Pierpont Securities

Interest rate volatility has increased since the start of June, which also increases prepayment risk and lowers demand for IOs. Higher volatility increases the risk that a bond will experience faster prepayments, which outweighs the benefit from scenarios with higher interest rates and slower prepayment speeds. For IO investors hedging with options, higher implied volatility also raises hedge costs and reduces carry.

Exhibit 2. Interest rate volatility increased in June and July

Source: Bloomberg, Amherst Pierpont Securities

The overhand of policy

Investors also worry that recent and potential policy changes could increase prepayment speeds. The FHFA recently eliminated a 50 bp upfront refinance fee that most borrowers had to pay, which could increase speeds. The director of the FHFA was recently replaced, raising the possibility that a new director might further lower the cost of a conventional mortgage and thereby increase speeds

Investors in Ginnie Mae MBS are also concerned about policy changes. The FHA recently introduced a loan modification program, the Advance Loan Modification (ALM), which will increase the number of delinquent loans bought out of pools. The FHA may also consider adding a 40-year loan modification, which could increase prepayment speeds more. Investors also worry the Biden administration will lower insurance premiums to increase mortgage affordability, which has the potential to increase speeds. And high home price appreciation over the last year raises the possibility that FHA borrowers could refinance into conventional mortgages to avoid paying mortgage insurance.

However, some relief may be on the way. The Federal Reserve is currently adding $40 billion of MBS to their portfolio each month and will eventually taper those purchases. Mortgage spreads are likely to widen when the Fed does this or even as the market anticipates tapering, which would push mortgage rates higher and speeds slower. And Yield Book is also planning to release their new model into production in August, which could allow market pricing to stabilize and bring investors back.