Once a readily available investment option, seasoned MBS’s are becoming increasingly scarce in the secondary trading arena, especially those with a par value in excess of $1MM.
True to form, 2020 closed out the year with record low mortgage rates. As such, homeowners are refinancing at a pace not seen since the financial crisis of 2009, and investors are seeing principal balances of MBS’s evaporate at record rates, both in their own portfolios and in the secondary market.
I’ve been concerned about this trend and its resulting impact on investment opportunities in MBS’s for some time now. As the MBS Specialist at SB Value, I recently received a request for an MBS PT (Mortgage Backed Security Pass Through) with very specific features. The investor set tight specifications for years to maturity, average life years, WAC (weighted average coupon), FMED rating, number of loans in the pool, CPR (Conditional Prepayment Rate) and, of course, yield.
It was a challenging request. Not just because of the investor’s specifications, but due to the dwindling supply of high par value MBS’s available for secondary trading. Consider the following:
As the above figure indicates, the 2020 Refinancing Index was the highest since 2009 and was double that of the average annual volume relative to the past six years. The result—the once high par value pool of MBS’s is rapidly diminishing.
So, what are the investment implications for financial institutions? Let’s look at it from a buy, hold, and sell perspective…
When buying, consider two points:
- First, a shift in your investment strategy mindset may be in order. MBS’s may still be a viable investment option, even when investing high dollars. Purchasing multiple positions with lower par valued securities in lieu of a single high par valued position can sometimes generate higher yields. For further insight, please read the following: “Generating Additional Yield Through Securities, Substitution and Aggregation” by John Sacchetti, Senior VP of Capital Markets.
- Next, consider the WAC (Weighted Average Coupon). The higher the interest rate paid by homeowners, the greater the prepayment risk. Consider less expensive, lower interest rate MBS’s. At the time of purchase, the yield would be adjusted to market and there is less prepayment risk. If you are interested in learning more about prepayment risk, the following brief delves further into the topic: “Mortgage Backed Securities, Mitigating the Risk of Prepayments” by John Sacchetti, Senior VP of Capital Markets.
When holding, be aware of the expected rate of prepayment, the potential for decreased returns in your existing portfolio, and the resulting surplus of funds that will need to be reinvested. There are two primary prepayment rates published for collateralized securities. They are as follows:
- PSA (Public Securities Association Standard Prepayment Model) is a statistical model, based on historical data and homeowner refinancing patterns, that reflects a monthly rate of prepayment, annualized to the outstanding principal balances of the pool of loans
- CPR (Conditional Prepayment Rate) is a statistical model based on factors such as historical prepayment rates for similar type loans and the current economic outlook. The CPR represents an annual paydown rate and is stated as a percentage of the outstanding principal balance.
When selling, keep the following two points in mind:
- It is common practice, and completely within regulatory bounds, for broker dealers to discount their offering price when buying securities and to mark-up their price when selling. Unbeknownst to the investor, these discounts and mark-ups are buried within the price of the bond. So, before you sell a position, especially in an environment of diminishing supply, ensure that you are selling at a fair market price. Please read the following white paper if you are interested in learning more about the impact of hidden mark-ups on community financial institutions: “What do Bond Mark-ups Really Cost Community Financial Institutions” by Dr. Edmond J. Seifried, Professor Emeritus of Economics and Business at Lafayette College, Dean of the West Virginia Banking School and the Virginia School of Banking, Executive Director of the Sheshunoff Affiliation Program
- Finally, think twice before selling an MBS with a low prepayment rate. Selling might be your best decision, but with the diminishing supply of high par valued MBS, you may not be able to replace it so easily.
The diminishing supply of high par valued MBS’s is just one of many factors we consider when providing investment advice on behalf of our financial institutional partners. If this is an area you need to explore further, please reach out to see how we may be of assistance.
ABOUT THE AUTHOR
Leslie Heath, Vice President - MBS Specialist
My true passion is sailing. Having spent my childhood living abroad in France, Germany, Libya, and Italy, we finally returned to the states when I was in my early teens. You would think that once we settled back home that I would never again leave solid ground, but I took to the water at 14 years old and have been there ever since. Many weekends are spent enjoying the calm waters, a seasonal breeze, and the setting sun.
With 35 years of extensive experience as a fixed income trader, I’d like to say that I started at age 14, as well, but alas, that is not the case. During those years, I developed a diverse investment background and currently specialize in mortgage related securities: MBS’s, CMO’s, ABS,’s, CMBS’s, ACMBS’s.
Being in the industry for so many years, I’ve had a front row seat for every ebb and flow of the market, and I find that there are many similarities between sailing and market cycles. Sometimes the wind is to your back, the waters are smooth, and it feels like it will never slow down. Other times its choppy, erratic, and unpredictable. As both a fixed income trader and an avid sailor, I find it’s best to be prepared for the unexpected, maintain a standard of excellence, and keep an eye on the horizon.