Tuesday, October 11, 2022
With the Federal Reserve (Fed) aggressively raising short-term interest rates in an effort to arrest generationally high inflationary pressures, interest rates across the U.S. Treasury yield curve have move higher in concert. The move higher in Treasury yields has put upward pressure on most other business and consumer interest rates including residential mortgage rates. As seen in the LPL Chart of the Day, the 30-year fixed national average rate for U.S. borrowers is above 7% for the first time since 2000. As such, home purchases and refinancing activity have recently fallen drastically.. Last week’s MBA mortgage applications index fell 14.2% in a week after declining 3.7% in the prior week. Importantly, purchase activity declined by 12.6% last week and refinancing activity declined by 17.8% after falling 10.9% the previous week. The Fed’s goal of reducing aggregate demand is clearly working in the housing market. Within the fixed income markets, mortgage loans that are bundled and sold to investors are a big component of the core bond universe. Agency mortgage-backed securities (MBS) are the second largest sector (behind Treasury securities) so the impact of a slowing housing market impacts the MBS market as well.
Agency MBS are AAA-rated securities and have government support in the case of a default so the biggest risks to this asset class is prepayment and/or extension risk—that is, as loans get prepaid due to a home sale or through a refinancing to take advantage of lower interest rates, the existing loan within the MBS market gets paid off early. MBS have an embedded optionality for the borrower with regard to the timing of principal and interest payments, so higher interest rate volatility, like we’ve seen this year, equates to higher uncertainty around refinancing and mortgage prepayments. This is the primary fundamental risk for MBS.
With the drop in home buying and mortgage refinancing, the maturity of existing bonds have extended and the interest rate sensitivity for the asset class is the highest it’s ever been. While this asset class has tended to be a defensive option during rising interest rate environments, the ability to protect from meaningfully higher interest rates is likely limited. However, the opposite is true as well. If rates were to fall from current levels, given the higher interest rate sensitivity, the ability of MBS to outperform has increased as well. As such, we think the risk/reward from owning Agency MBS has increased and we believe the asset class provides an attractive investment opportunity.
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