US MBS historic rebound from prior months depths

• Rates Rally Fuels Outperformance
• Discounted Coupons Ride the Wave
• GNMA II 7% Squeeze Exposed

From the ashes rises the Phoenix, our new name this month for the MBS complex. Wides became too inviting to ignore, and given the right macro backdrop, spread product exceled. Such was the case with salacious MBS spreads and a Fed squarely in the rear-view mirror.   

MBS Supply has not been an intrusion to performance the past year or so, and even forced selling has receded with no bank or investor implosions on the horizon as central bank rates maneuvers ebbed. With prepayments contained as well, the setting was conducive to tightening, as both domestic accounts and foreign concerns fueled the outperformance. 

MBS index performance for November was a sparkling +537 basis points in Total Return (MTD), with excess returns to duration neutral Treasury index +152 bps-the best since November 2022’s record Prices were over +4 points higher, outpacing Treasuries by nearly two points. The 10yr yield fell -60 basis points off the lofty levels from September and October, fully retreating inside 4.40%. 3m10y Vols (normalized) dropped 16 basis points to +112 as event risk dissipated. Lastly, the 2s10s curve flattened 19 basis points into the rally, net -36 basis points overall. 

Originator supply dropped to $1.8 billion per session, its lowest since January as the housing season shuts down into the winter and only the largest of rates moves can shake out supply. Speaking of supply, 7.5s (net coupon) have regularly surfaced in daily TBA hedges, given the higher perch on retail offering levels. 7.5%s are now almost 4% of the pipeline that is still supported by 6.5%s and 7%s at 79%. The 30yr FHLMC primary rate took as sharp drop to 7.22%, while Bankrate’s daily quote plunged 45 basis points to 7.57% after opening the month above 8%.  

Hedge funds and Money Managers took a more constructive bias toward current and higher coupons this month, feasting on higher coupons and ample spreads to outgun any selling. Lower coupons remain at the mercy of rates, rallies benefit this fully extended PO (Principal Only) like sector while sell offs treat it like the long-ended step cousin its morphed into being.  

Class C (GNMA) dollar roll trading has mostly been a sluggish market, with stagnant prepay speeds and ample supply calming the waters. This past month of November proved to be different for Class C settlement.   

From the start of the month, the bid on the roll popped to double digits (10/32nds) as higher yields sparked Asian demand for their beloved AAA rated, direct U.S. obligation GNMA (II) sector. Historically, Japanese buyers are very picky in terms of awaiting a so-called “bogey” or preferred entry level on MBS. The yield must be high enough for them to buy and hold, which is understandable, as no one wants to get extended out (duration) unless the return offers adequate compensation.

Added to the mix is CMO shelf accumulators, whose previous monthly collateral needs were focused lower in coupon, again with no ill effects to the market via their consumption.

However, in the case of GNMA II 7%s, where supply is 1/3 of lower deal coupons, the effects were both immediate and revealing.

Each month GNMA issues one MA pool for each 50-basis point net coupon, that serves as good delivery for that TBA. This multi-issuer pool is a veritable all-encompassing hodgepodge of issuers, both good and bad. The remaining pools are not good delivery specified/Custom pools (unlike UMBS). This reduces the float for Class C (GNMA) settlement.

September’s GNMA II 7% MA pool was MA9174 ($1.4B), October’s GNMA II 7%s MA pool was MA9244 ($1.8 billion). The November MA pool (MA9308) was $2.933 billion, larger than the prior months, as lending levels rose sufficiently to populate a net 7% coupon. Demand, as noted, was greatly increased.

Using a 9 CPR (October aggregate) on GNMA II 7%s, break-even (“carry”) was 2 7/8ths 32nds, implying a 3.64% funding rate-very special when compared to LIBOR and SOFR levels of 5.4%. 

As interest rates move higher, there is always the danger supply being limited as loan underwriting lags into the uptick-borrowers naturally balk at increased borrowing costs. Added to that, is the seasonality of the housing slowing into winter months, even fewer loans written.

Alternately, bond demand increases as yields surges, however this time of year that is offset into year-end as investors close their books in the United States. For Asia, that year end occurrence is set for March 31-lots to consider from an investor perspective. That’s when the basics of dollar roll funding come to the forefront, as rolls trade special and funding favors the pool holder. 

A 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 22 to 26 basis points as the current coupon fell.

The 30yr current coupon (30yr CC) lowered 78.5 basis points (5.87%), OAS and ZV firmed 22 to 26 basis point to 36.14 and 134.6 respectively. The highly followed benchmarking to 5&10yr Treasury comparison tightened 26bps to +154.7-a level not seen since the summer.    

A grinding rally from the end of October to month end-which usually portends widening from here. Countering that assumption is year-end slowdown in trading flows, so that we may hold into 2024.

The Current Coupon for 2023 has risen 53 basis points (net of rallies and sell offs). This encompasses volatile events in both directions, banks failures and Fed rate hikes-quite a year.

The other parameters show OAS 26 bps wider, while ZV and Tsy spreads were one to 11 bps wider, firming from the abyss as we approach the countdown to year end.