Attractive starting valuations and a supportive rate outlook have prompted Morgan Stanley’s mortgage-backed securities analysts to shift their recommendation on the sector to overweight from neutral.
This is understandable as the Fannie Mae option-adjusted spread over both Treasuries and Libor shows them both wider year-to-date, with the latter offering about double what it did at the end of 2018. Morgan Stanley joins other firms who are overweight the sector such as R.W. Baird, who state mortgages valuations to be compelling “especially when compared to other spread products.”
The U.S. investment-grade corporate index option-adjusted spread over the MBS index is close to the tightest it has been in half-a-decade while rate volatility, no friend of mortgages, has been falling since the summer.
The sector has been hit by a refinancing wavelet as the 30-year mortgage rate dropped to a multi-year low of 3.49% in early September. Consequentially, the TBA deliverable in UMBS 30-year pools have sported prepayment speeds that rival those seen in their traditionally faster Ginnie Mae counterparts. A recent report from Wells Fargo & Co. shows UMBS 30-year pass-throughs delivered to settle TBA trades exhibited 1-month CPR of 35, 54 and 56 for the 3.5%, 4% and 4.5% coupons, respectively, from just 11, 20 and 27 four months ago.
A conditional prepayment rate (CPR) is a loan prepayment rate equivalent to the proportion of a loan pool’s principal that is assumed to be paid off ahead of time in each period
Still, now may be the time to climb on board mortgages. As of late the 30-year mortgage rate has risen back to 3.75%, reducing the percentage of conventional borrowers with incentive to refinance to 40% from 65% in early September, according to Scott Buchta, head of fixed income strategy at Brean Capital. Consensus forecasts that prepayment speeds will drop about 12% in the next report, while traditionally net supply tends to be relatively light in the first half of the year.
Naturally, risks still abound, from a recent FHFA proposal to modify the GSEs’ pooling practices to a myriad of geopolitical concerns that could send interest rates tumbling lower again, sparking a renewed refinance wave.
Christopher Maloney is a market strategist and former portfolio manager who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice
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