An investor's view

SCI spoke to Brendan Doucette, government bond portfolio manager of GW&K Investment Management in Boston. The firm has assets under management of $40bn, of which $1bn is invested in the MBS market. It invests only in GSE-backed bonds.

Q: Where do you see value in the MBS market at the moment Brendan?

We like owning mortgages versus Treasuries, but it is a little bit more difficult to make the case versus corporates. We have come back closer to neutral on MBS given the intervention in the market by the Federal Reserve. We’ve sold out of some of lower coupon pools that the Fed was buying. We think higher coupon pools offer good value at the moment at the moment, specifically specified pool MBS. Given the bear steepening in rates over this quarter we like keeping our key rate duration concentrated in the front end, as this is where the Fed can control rates a little bit better. We’re told they aim to keep rates stable over next couple of years.

Q: What value do you see in specified pool MBS?

Quite a lot of specified pool bonds were fire sold by leveraged investors in March to meet margin calls. We saw significant value there at the time and we continue to add to our holdings of specified pools. Although mortgage rates are now at all-time lows, the secondary spread is still high so we think mortgage rates will drift continue to lower and  specified pools will continue to provide value. We’ve seen pay-ups on those pools increase significantly this quarter.

Q: Why do you think mortgage rates will go lower still?

The so-called secondary spread is a key indicator. This measures the 30yr mortgage rate minus the 30y MBS yield. It’s at 165bp right now, but the historical mean is around 100bp. What this is telling us is there is further room for mortgage rates to drift lower, particularly as the Fed does purchase operations. It clearly wants to narrow that spread. It was as wide as 200bp in worst days of the recent sell off. Currently, the 30y mortgage rate is around 3.125%, so it could drift lower by 40bp-50bp to a fair value 30y mortgage rate of, say, 2.625%.

Q: Obviously, forbearance rates have leapt since the beginning of the Covid 19 crisis. This should feed through to greater delinquency as well. How do you see this development as an investor?

From an investor’s perspective, forbearance and delinquencies create opportunities. There are certain dates and specified pools that will have higher delinquencies. This can be beneficial as it will slow down prepayment speed more than projected. So we like owning low FICO, high LTV MBS and also pools from certain areas of the country, like New York. Wells Fargo, for example, has shown delinquencies that are two times greater than other multi lender pools. I saw a report which said Wells Fargo delinquencies were running at 8.9%, compared to a multi-lender average of around 3.2%.  This is something that creates opportunities for us. With higher delinquency rates, you get slower prepayment, especially in the higher coupon pools, so you can get a lot more carry.

Q: What about the CMBS market? Where are you seeing value there?

We like Freddie K paper. This got pretty wide lately, north of 150bp over swaps. The latest deal this week priced at low 40s in A2 tranche. We own 6 year to 8 year, which admittedly carries quite a high dollar price as there is not much of a bank bid. However, that paper is in 60s/70s and we find that pretty attractive, particularly as it is eligible for Fed operations. It has been buying paper in the 5 year-8 year weighted average life area.

(SCI: The last Freddie K deal was announced by Freddie Mac on June 11. The GSE said it “recently priced” a $729m multi-family MBS, incorporating four tranches. The A1s were swaps plus 65bp, the A2s were swaps plus 75bp, the X1s were Treasuries plus 385bp and the X3s were Treasuries plus 675bp).

Q: What is your view on the outlook for the primary MBS market in the remainder of 2020?

The primary market is the biggest risk to mortgage rates. Origination supply is very elevated and there is also a higher than normal securitization rate from lenders. Rather than holding the loans on their balance sheet lenders are securitizing them immediately, and this trend towards greater securitization will continue. Lenders don’t want to be stuck holding a loan that goes into forbearance. So we will see more net supply, I think. This could be tempered by refinancing, which has started to come back, and the Fed will take a lot of this supply that will be hitting the market from higher securitization rates but it remains a risk.

Q: What kind of supply do you think we’ll see then this year?

From the GSEs we’ll see net supply of around $250bn in the TBA and specified markets. The Fed has been pretty transparent about its intentions, which is why I think a lot of the Fed buying has been priced into the lower coupons. The Fed has already taken down $700bn since March and will do about $40bn net per month.

Q: Purchase mortgage applications have rebounded a lot, and we’re seeing something of a V shaped recovery here. Why is that, do you think?

Applications are up again this morning so there continues to be this drive of people to purchase homes. There was a dip there is some pent up demand. Millennials need a place to live and there’s not enough inventory in the market. Applications are higher than they were a decade ago. plateau of Mortgage forbearance seems to have plateaued, and this week started to drop ever so slightly.

I also think the market underestimated how much difference could be made by technological advances and the speed of regulatory changes in order to increase closing of mortgages. Everyone thought Covid 19 would impact mortgages closing much more than they did. They were much higher than expected last month, and this factor will affect market going forward, leading perhaps to greater convexity.

Q: The first subscription date for TALF 2.0 loans was yesterday, June 17. What do you think the take-up will be?

We are not participating in the TALF market. It’s chiefly a non-agency/ABS market. From what I’ve seen, a lot of the spread might have been taken out as once it was announced ABS tightened in significantly. The windfall that people got in the great financial crisis ten years ago just isn’t going to be there.

Simon Boughey