MBS languishes as the market waits for the banks and the Fed

Like many in the US ABS market, portfolio manager Brendan Doucette is waiting for the Federal Reserve to issue new guidance on Basel III Endgame (B3E).

He runs a US$1.5bn book at Boston-based GW&K Investment Management, 90% composed of agency MBS, and the implications of B3E have taken bank demand largely out of the market.

Until more clarity is offered on the extent to which the Fed is prepared to row back from its initial version of B3E – if at all – the bank bid is out of the market.

The situation is further complicated by uncertainty about cuts in rates. At the beginning of the year, the market frothily priced in up to six rate adjustments, but by the end of H1 nothing has happened. Inflation has not receded as much as the Fed had hoped, and only two cuts are now expected before the end of H2.

MBS securities are particularly sensitive to rates due to prepayment risk, and this adds to the reluctance to add duration in the form of MBS risk many on the buy side feel. Fewer rate cuts that were forecast six months ago have excised the prepayments that were built into models.

“Banks are waiting on more clarity on B3E and a better sense of the Fed rate path. The persistent inverted yield curve and uncertainty around the Fed and Basel III are keeping the banks on the sidelines. I anticipate more transparency on both items in the second half of the year, which should lead to more bank participation,” says Doucette.

The lack of bank demand has allowed MBS yields to creep higher, particularly as the Fed is continuing to roll mortgage paper off the balance sheet at a rate of around US$15-20bn per month. To some extent this has been offset and technicals boosted by low new issuance volumes, but a return of bank buying would come in handy.

Spreads in, say, unsecured corporate debt, are narrower because there is less reliance on bank buying and, as there is no prepayment risk, they are less correlated to the likelihood of rate cuts.

Volatility was generally low in H1, with the exception of when Truist sold its remaining stake in Truist Insurance Holdings to a private equity consortium for US$15.5bn in February, the gains of which were offset by selling lower coupon MBS bonds in May.

It is expected to remain low in H2, especially as the expectations for Fed rate cuts have been downscaled so significantly.

Finding value in H1 has not been easy in H1, but bonds comprised by 100% Florida-based mortgages proved an exception. There has been higher price appreciation in this state than most in the first six months of the year, and turnover has been higher as well in part due to higher insurance costs and state taxes.

“One hundred per cent Florida specified pools generally have a CPR (conditional prepayment rate) which is one to two CPR faster than generic pools when they are 200-300bp out of the money to refinance. This seems like an insignificant amount, but it is a performance driver when the pools are trading at a 10-point discount to par,” explains Doucette.

Simon Boughey