ETF Trends sat down with Mark Carlson, Senior Investment Strategist at FlexShares Exchange Traded Funds, to discuss mortgage-backed securities.
Mark, last week the Federal Reserve reiterated and clarified its policy announcement indicating that rates would remain at zero until at least 2023. What implications does this have for the mortgage market?
One of the implications of falling interest rates and the Federal Reserve’s return to a sustained zero interest rate policy has been a surge in mortgage refinancing as homeowners try to take advantage of low rates.
Prepayment speeds on existing mortgages have accelerated since the initial COVID-19 shock, and the MBS market is seeing very high prepayments during the coupon stack and origin years. Reports on agency prepayments on MBS pools created in 2019 show annualized prepayment rates of more than 30% during the month of August. With 10-year and shorter Treasury yields dropping more than 100 basis points year-over-year, it makes perfect economic sense for homeowners to refinance.
Probably the only mitigating factor holding back the refinancing activity is the fact that the mortgage lending system is working at full capacity. The industry is making progress in using technology and data to speed up the process and hire more staff, however the fallout from poor underwriting and documentation performance during the credit bubble, which contributed to the GFC, home and home institutions. Mortgage services are now making sure to dot every “I” and cross every “T” to avoid legal fallout.
These powerful shares in the market led to a sharp rise and record surge in MBS supply to the tune of $ 322 billion in August alone, a new monthly record.
Despite this record increase, the Federal Reserve and other banks and institutions absorbed the offer by providing support for the asset class.
The Federal Reserve continues to buy MBS in its open market operations, up to $ 200 billion per month as part of its policy framework to “support market functioning and help promote accommodative financial conditions.”
Meanwhile, banks and other institutions holding record amounts of cash and deposits are turning to agency mortgages to earn higher income with quasi-governmental tools.
The sector is likely to attract more individual investors as the pace of refinancing eases over time and the attraction of a premium yield on Treasuries proves too difficult to ignore
What are some of the concerns that investors should be aware of when investing in mortgages / MBSs?
The health of the global real estate market right now is something to watch out for. While the housing market has generally rebounded from relative lows reached during the height of the pandemic, many are keeping an eye on the potential for additional stimulus and ongoing loan-tolerance policies that could support homeowners. But the housing market has been resilient and the amount of forbearance loans has steadily declined, currently at its lowest levels since April.
One of the main risks associated with mortgages that many investors underestimate is the prepayment risk and its impact on duration and returns.
As mortgage rates fall (and in the future, it is assumed that they will move higher), assumptions about prepayment speed increase (or decrease as interest rates rise), which reduces effective maturities (increases actual maturities in rising rate environments). This is known as the contraction / extension risk. Since duration is THE most important factor in predicting fixed income returns, managing the duration of an investor’s fixed income portfolio is crucial.
The current challenge for investors is reinvestment risk, as loans are refinanced at lower rates, prepayments accelerate, and principal is returned to MBS investors who must then reinvest those proceeds at lower current rates and potentially longer maturities. reducing the cash flow of income while potentially adding more interest rate risk to their portfolio.
Given the expectations that this extremely low rate environment will continue for the foreseeable future, how can investors focus on maintaining the income stream?
The agency’s MBS (Ginnie Mae / Fannie Mae / Freddie Mac) offer an attractive risk / return solution over short-term government bonds and corporate credit, offering a premium over the risk-free rate for a risk of similar credit and can be used as a tool to reduce credit risk compared to companies with only a slight reduction in potential returns.
With a 5-year Treasury yield of less than 30 basis points, investors can gain additional income by taking on a marginal amount of credit risk with an average return of 135 basis points on the MBS.
Investors should be aware of the duration risk with their MBS investments. A key difference during this ZIRP environment versus post-GFC is the change in the Federal Reserve’s approach to the inflationary component of its dual mandate. At the September FOMC meeting, the Fed stated a policy to allow inflation to “heat up” after periods of less than 2%, meaning the Fed will be less likely to raise rates in the face of inflation, which means that the yield curve could steepen as investors’ inflation expectations rise and nominal yields are pushed further out of the curve. This rate movement would have negative implications on total return if MBS maturities lengthened as the pace of refinancing eventually runs out and prepayments slow down to more traditional levels
The FlexShares MBSD fund is designed to limit duration to around 3.75 years, with an upper / lower duration range of 50 basis points. MBSD offers investors the greatest income potential of MBS by reducing the increased risk of extension / contraction in duration associated with the changing environment for mortgage prepayments.