After the Major Summer Spread Widening, MBS Snap Back to Fair Value

The third quarter of 1999 began with a major spread widening across market sectors. By early August, the interpolated current coupon pass-through spread to the 10-year Treasury had widened to 180 basis points. Except for six trading days in the turbulent period of October 1998, this represented the widest current coupon spread since 1986.

In notable contrast to October 1998, the current coupon spread increased nearly 60 basis points without any surge in MBS supply or major liquidations of leveraged MBS portfolios. On the contrary, pass-through issuance subsided after the 1998-99 refinancing wave ended, while MBS trading volume throughout the summer remained moderate.

The Russian debt restructuring in August 1998 spawned unprecedented spread volatility in fixed income markets. Since then, across the major sectors of investment grade spread products, yields have moved in closer correlation to each other than with those of the Treasury market.

Over the past six months, the current coupon pass-through spread to the 10-year swap rate (a benchmark for high quality intermediate duration spread product) has remained within a 21-basis-point range By contrast, its spread to the 10-year Treasury has fluctuated within a 59-basis-point range (121 to 180).

It was a major widening of swap spreads, due in large part to heavy issuance of corporate bonds, asset-backed securities, and CMBS during the summer months, that led to the exceptional MBS spreads prevailing during August. Reacting to the unusually high volatility of spreads over the past year, dealers and leveraged investors have begun to substitute interest rate swaps for Treasuries and futures to hedge long positions in spread product. This increased the demand to pay a fixed rate and receive a floating rate in the swaps market.

But there was little interest in receiving fixed and paying floating. As swap spreads and competing spread product widened, MBS spreads had to widen in sync with them in order to entice buyers. We have entered an era in which the overall supply-demand balance for investment debt instruments exerts a stronger influence on MBS spreads than the specific supply-demand balance in the mortgage market.

In addition to increased supply of competing spread products, concerns about potential difficulties in financing MBS positions over year-end 1999 contributed to the wide MBS spreads prevailing in August and early September. The Federal Reserve helped alleviate these concerns when the Federal Reserve Bank of New York announced on September 8 that the FOMC had authorized the System Open Market Desk to accept agency pass-throughs (but not CMOs) as collateral in repurchase transactions.

Tri-party arrangements for management of the clearing and settlement of MBS collateral are now in place and, early in October, the Fed began accepting pass-throughs in term repurchase transactions with January expiration dates. This helped allay investor concerns that the reluctance of dealers to carry large positions over year-end would cause dollar rolls to trade below fair value. Accordingly, MBS spreads have narrowed over the past month.

With year-end financing concerns abating, and with issuance of spread product slowing in September, investor buying tightened spreads across all fixed income products in September and early October. Declining pass-through supply and falling implied volatilities in the interest rate derivatives market helped the MBS sector outperform competing spread product. By mid-October, current coupon spreads to Treasuries, bullet agencies, callable agencies, and swaps have been close to their six month moving averages.

MBS Currently Fairly Valued, but Fundamentals Justify a Modest Overweight versus Treasuries

The September spread tightening brought the MBS market back to normal historical relationships with competing spread products. The current coupon spread of 147 basis points over the 10-year Treasury, however, remains much wider than the 89 to 116 range that prevailed for the two years prior to the August 1998 Russian debt restructuring. While we doubt that MBS spreads will return to that range in the near future, we believe that there is room for additional tightening over the next three to six months.

First, with 10-year Treasury yields forecast to remain in a fairly tight trading range around the 6% level through the first half of 2000, implied volatilities in derivative markets should continue to trend lower, reducing the option cost of pass-throughs. Secondly, corporate bond issuance is likely to fall-off as year-end nears. Issuance will remain heavy in October as corporate Treasurers seek to secure their 1999 financing needs well before fixed income investors close their books for the year. In addition, Y2K concerns are likely to accentuate risk avoidance by fixed income investors this December.

Finally, the normal seasonal decline in housing turnover should reduce net MBS supply between now and February. Rapid housing turnover during the summer of 1999 prompted heavy selling by mortgage bankers that, in turn, contributed to the spread widening from May to early August. Falling turnover reduces the risk of spread widening through the upcoming winter months.

While conditions are not as favorable for MBS outperformance as those that led us to recommend a substantial overweight in early August, the risk-reward tradeoff for the MBS market still favors a modest overweight. The new Fed policy of accepting agency pass-throughs in repurchase transactions should virtually eliminate the possibility of a near term return to the 180 basis point current coupon spread that occurred in August.

The Prepayment Outlook: Slower Does Not Mean Slow for Housing Turnover

We have consistently argued our view for the past year and a half that the provision in the Taxpayer Relief Act of 1997 that liberalized the taxation of capital gains taxes from home sales would permanently increase housing turnover. As successive demographic cohorts move through the life cycle, they may now freely choose the housing that suits their family size and economic status without being deterred by capital gains taxes.

In addition to this important long-term factor, the prevailing high level of consumer confidence and favorable demographics will continue to prop up home sales in the months ahead.

There has been much recent attention in the financial press to the slowing of housing demand due to higher mortgage rates. The Freddie Mac weekly 30-year average survey rate has risen 133 basis points from its record low of 6.49 one year ago to 7.82 currently. While that has recently driven the Mortgage Bankers Association of America (MBAA) Purchase Application Index down 9% from last year's record level, this index remains over 20% above the early fall average of any year before 1998 (the index began in 1990). With respect to the pace of mortgage originations and the level of housing turnover, the 1998-99 period has been unlike any prior period in the 30-year history of the MBS market.

We believe that for the remainder of 1999 and throughout 2000, housing turnover will continue to be approximately 15% faster than the peak pre-1998 levels, barring a major increase in mortgage rates from current levels. Therefore, the continuation of historically rapid prepayment speeds on discount mortgages underpins our relative value judgments for the residential MBS market.

We expect prepayment speeds for premiums to continue their recent declines for about three more months. Thereafter, premium speeds should level off at CPRs close to dealers' median long run forecast levels.

Relative Value Opportunities in MBS For the Remainder of 1999

In the conventional pass-through market, current coupon 7.5s are slightly rich to discounts, especially to deep discount 6s and 6.5s. For those seeking a longer duration, 30-year 6s and 6.5s represent the best values in the conventional market. For those who want a shorter duration, a barbell of 6.5s and 8s represents better value than 7.5s.

While investors sometimes prefer current coupons for their attractive dollar rolls even when discounts are cheaper, we doubt that rolls will trade significantly above fair carry value for the remainder of the year. Diminished mortgage banker selling in the back months and reduced CMO issuance (hence less demand in the front month) has made the dollar roll market less attractive for return enhancement. Since both of these trends seem likely to intensify in November and December, we doubt that the roll market will significantly enhance returns for current coupon investors over the balance of this year.

The GNMA market bounced back in September after ending August at very inexpensive levels compared to conventionals. After trading considerably below fair value for much of 1999, GNMAs are now only slightly cheap on an OAS basis to conventionals. Two weeks ago, it looked as though Congress might approve a proposed GNMA portfolio.

But it now appears that Congress will enact the VA-HUD Appropriations bill that omits the provision authorizing GNMA to purchase a portfolio of GNMA MBS. While the leadership of GNMA is strongly committed to the portfolio concept, it appears to be virtually dead for 1999.

Eventually, approval of such a portfolio seems likely, but GNMA investors cannot expect any near term return enhancement from that prospect. For the present, we remain neutral on conventional-GNMA swap levels and recommend a market weight for GNMAs.

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