Thoughts on Tricks and Treats for MBS Investors

Chris Helwig | November 1, 2024

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. This material does not constitute research.

This year has been, for the most part, a year of treats for MBS investors across both the agency and private-label markets. In the spirit of All Hallow’s Eve, both agency and private-label MBS investors may be on the lookout for a ‘trick’ in the form of idiosyncratic bank demand for MBS. Conversely, mortgage derivative and non-QM investors may be in for a ‘treat’ as a result of a further steepening of the yield curve.

Trick: MBS get ‘ghosted’ by US depositories, leaving agency, non-agency spreads wide

Mortgage basis and non-agency spread performance for the rest of this year and beyond will, in large part, be tethered to net demand for MBS from US depositories. Bank demand for MBS has historically been somewhat predictable, as it has surged along with a rally in front-end rates. Said another way, there has been a negative correlation between front end benchmark rates and bank demand for MBS. However, that relationship may not hold in the current Fed easing cycle.

Bank deposits tend to grow as interest rates decline, mainly because lower rates disincentivize investors to tie their money up in longer fixed income investments. In more recent Fed easing cycles, rate cuts were often paired with multiple rounds of Quantitative Easing, which further fueled deposit growth as the Federal Reserve pushed excess liquidity into the system. Furthermore, as short rates fall, the basis between what banks can earn by investing out the curve relative to what they can in the overnight market widens, making investing out the curve a viable strategy to defend net interest margins (NIMs) into lower rates. The combined effect of deposit growth and NIM positioning has historically driven strong bank demand for MBS into lower rates (Exhibit 1).

Exhibit 1: Banks have bought more MBS as rates fall

Source: Santander US Capital Markets, Federal Reserve H.8, Bloomberg LP

Precedent suggests that more dovish positioning from the Federal Reserve should bode well for bank demand, but past is not always prologue and much has changed since the Fed’s last cutting cycle. The aggressive run up in interest rates in 2022 drove a contemporaneous extension of asset and contraction of liability durations across certain banks’ balance sheets, pushing several ultimately into FDIC receivership. These failures cued a somewhat seismic change in how banks manage their investment portfolios, eschewing longer duration, more negatively convex MBS for shorter duration more convex cash flows. The shift has been relatively painless for depositories given the absolute level of front-end benchmark rates over the past two years.

Recent bank buying suggests that demand may be episodic and opportunistic rather than prescriptive going forward. Additionally, banks may be more likely to buy MBS when rates are relatively elevated rather than depressed. Under the assumption that banks drive most of the demand for agency CMOs, there was a material uptick in buying in the wake of the last non-farm payroll report and subsequent sell off, creating the opportunity for depositories to lock in higher book yields on fixed-rate investments (Exhibit 2).

Exhibit 2: Banks buy MBS as rates sell-off

Source: Santander US Capital Markets, FINRA ICE Data Services (TRACE)

If bank demand becomes more episodic given heightened sensitivity to what absolute yields these institutions are putting on the books, this could drive a more barbelled approach to portfolio investments, particularly if the yield curve continues to bear steepen. Higher absolute rates and increased volatility on the longer end of the curve may lend itself to opportunistic bank buying of longer-dated, more positively convex MBS. While this may seem somewhat counterintuitive to the overall trend towards reducing portfolio duration, longer duration, locked out MBS would be paired with either a substantially larger allocation to either floating rate MBS or reserves held at the Fed to offset the majority of the duration.

Ultimately, more muted or idiosyncratic bank buying of MBS should weigh on the MBS basis and non-agency MBS spreads by proxy. While the effect of bank demand on agency spreads is a fairly straight forward relationship, the influence on non-agency is potentially less so. The impact on non-agency spreads will be most acute in more negatively convex non-agency exposures like prime jumbo, Non-QM and potentially closed end second lien transactions. Nominal and option-adjusted spreads, particularly those of higher coupon agency MBS, will ultimately serve as both a relative value benchmark and a potential governor on ‘AAA’ spreads across more negatively convex private label exposures.

Money managers investing for mutual funds will require a concession in both nominal and OAS terms to sell the liquidity associated with investing in private label versus agency MBS. Recent price action suggests that elevated front-end benchmark rates may help keep spreads anchored by yield buyers, particularly insurance companies, but as the Fed continues to cut rates, the bid from yield buyers will likely abate to some degree, making the relative value proposition more pronounced.

Treat: Steeper yield curve boosts valuations for CMO derivatives, non-QM

While polling remains tight, an eventual Trump victory would likely be constructive for mortgage derivatives broadly and inverse IO specifically. A Trump administration would extend tax cuts implemented in 2017 during his former administration. Per a CBO report issued in May, continuation of these cuts could add a net $3.3 trillion to the national deficit across a roughly 10-year horizon. Growth in Treasury supply needed to fund the larger deficit would likely steepen the yield curve via a long-end bear steepening. Increased government spending under a potential Harris administration could net the same effect as tax cut extensions but that outcome is more nebulous and harder to quantify. A further sell off on the long end of the yield curve due to growing Treasury supply in either scenario would likely be concurrent with further Fed easing on the front end of the curve.

Inverse IO (IIO) backed by currently in-the-money collateral will have the most upside to a contemporaneous rally in the front end and sell-off in the back end of the yield curve. And of IIO backed higher WAC collateral, bonds with lower strikes should outperform within that cohort given more front-end key rate duration.

Looking at both effective and key rate durations across a handful of various inverse IO profiles shows that, when compared, a bond like GNR 2023-154 KS which is a 6.35% strike IIO backed by loan balance G2SF 7.0% collateral, has comparable two-year key rate duration to profiles with lower strikes but substantially more negative key rate duration than bonds backed by lower coupon cohorts. As a result, it should substantially outperform into a steepening of the curve where both the front-end rallies and the long end sells off (Exhibit 3).

Exhibit 3: Comparing key rate durations across IIO profiles

Source: Santander US Capital Markets, YieldBook

Additionally, Non-QM cash flows, particularly recent vintage, higher WAC ‘AAA’ bonds should benefit from a front-end rally and longer end sell-off as well. Historically, under more parallel rallies in the yield curve, these bonds have had limited ability to hold duration, curtailing total return. These cash flows inability to hold duration was resultant from prices being capped despite lower rates as investors became increasingly premium averse in the face of faster prepays and increased callability as prices on loans underpinning the deal rose.

A non-parallel shift in the yield curve described above would have the opposite effect, dampening prepayments and reducing collateral valuations. In this scenario, the front end would continue to rally, and given the majority of key rate duration in Non-QM ‘AAA’s is anchored on the front end of the yield curve, bonds would hold that duration better, allowing prices to appreciate further than in previous rallies. An additional consideration in this scenario is that while these bonds would be pitched against a steep forward curve, currently elevated cost-of-funds associated with recent issuance combined with additional step-up features would likely incentivize sponsors to re-lever these transactions against lower future front end rates, mitigating material extension risk that would drive these cash flows key rate durations further out the curve.