US MBS finishes 2023 strongly

• Final two months make the year.
• Fed recedes and supports.
• Originations lower again.

Once the Federal Reserve stopped hiking rates and ultimately left the door open for rate cuts in 2024, fixed income markets were off to the races. The MBS stack, dominated by lower discounted coupons benefited greatly with lower coupons sporting “positive” convexity and rallying with longer treasuries. Sellers became buyers and 2023 closed out with positive returns all around.  

The year just concluded was anything but a given, as bank failures, subsequent FDIC auctions, Fed Rates hikes (to ward off inflation), then rate cut pauses (to acknowledge inflation was contained) all worked in concert to roil the markets both positively and negatively.  Predictions of a recession were off the mark, while global recoveries aren’t a sure thing either. All in all, once interest rates and volatility were calmed, bonds and stocks had a banner close to 2023.

MBS index performance for December was another solid performance all around; +439 basis points in Total Return (MTD), with excess returns to duration neutral Treasury index +91 bps: bringing the YTD results into positive territory. Looking back over 2023, the 10yr yield was net higher only 7 basis points to 3.86% from a starting point of 3.79%. Meanwhile, the slope of the 2s10s yield curve did “steepen” 25 basis points to a less inverted -37.5 basis points. Accounting for receding event risk as the year moved along, the closely followed 3m10y Vols (normalized) measure dropping 25 basis points from its October highs to close at +114 was about as good as it was going to get.

Originator supply never really got going this past year, as lofty rates and rising home prices quelled borrower appetites, with only mid-summer offering daily levels nearing $2.8 billion before dropping to end of year depths of $1.5 billion per session. The pipeline composition itself was predicated upon interest rates moves, as Fed hikes necessitated coupon hedges of 7.5% at times, while year-end rallies pushed supply back to 6% dominance. The 30yr FHLMC primary rate peaked in October at 7.79% in the weekly PMMS reading before tanking into year-end at 6.61%. Finally, Bankrate’s daily quote crested above 8% in late October before diving to 6.93% by the end of December-still 36 basis points above its January 2023 starting point.   

Before the end of year rates rally, 10yr yields had risen 170 basis points to its peak around 5% in late October. Additionally, the push to mortgage rates saw 30yr prime fixed levels crest near 8 3/8%. That was a major deterrent to MBS production and virtually eliminated the refinance aspect of mortgage underwriting (just 13.7% of 2023 agency production).

As you can see from the table below, the majority of issuance was centered around 5.5% net coupons, with a gross note rate of 6.31%. As lending rates rose, production up the coupon stack stalled.   

Looking back over the past decade, to the glory days of recent MBS issuance, production peaked in 2020-21 as the Federal Reserve cut rates and post Covid levels had yet to recover. Back-to-back years of $3 trillion+ in issuance seemed the norm even as a new base of borrowers were now locked into 2% and 2.5% net coupon (gross note rates 2.75% to 3.13%).  This ultimately set up the current state of lending affairs, with 97.69% of the outstanding MBS Agency Universe “out of the money” to refinance against current rates.

MBS issuance is mostly a function of prevailing interest rates, with a nod toward borrower predilection against their own predicament. When their current needs are met, and new purchases not pressing another borrowing, the scale tilts toward no activity as we’ve seen the past few years.  

Solid turnaround for the discount laden MBS complex with rates rallies and price gains benefitting the index massively. Buyers swooped in at the wides, firming spreads 6 to 13 basis points as the current coupon fell.

The 30yr current coupon (30yr CC) lowered 61 basis points (5.25%), Option-adjusted spreads (OAS) and Zero Volatility (ZV) spreads firmed 6 to 11 basis point to 24.7 and 128.2 respectively. The highly followed benchmarking to 5&10yr Treasury comparison tightened 13bps to +141.5-retracing fully to early summer levels.

Q4 rally from end of October to end of year-likely holding into Q124 as seasonal slowdowns in trading flows and range trading offsets tendency to take profits.

The Current Coupon for 2023 has lowered 7 basis points (net of rallies and sell offs). This encompasses volatile events in both direction, banks failures and Fed rate hikes-quite a year.

The other parameters show OAS 15 bps wider, while ZV and Tsy spreads were one to 4 bps tighter, firming from the abyss as we approach the countdown to 2024.