Maya Angelou quoted “You can’t really know where you’re going until you know where you have been.” Who knew this quote would also apply to the Mortgage-Backed Securities (MBS) sector? In this blog, we look back at the major themes that impacted the MBS sector in 2020 as well as highlight some of the points that remain in play as we proceed into 2021.

Theme 1: QE4

2020 started off quietly but quickly unraveled and became a year to remember - for many reasons. The chaos in the markets unfolded and influenced the course of MBS market immensely.  Mortgages came under pressure as liquidity vanished and spreads widened. The Federal Reserve (Fed) announced QE4 in March, removing nearly USD 500bn of supply from the private market in March & April alone. The magnitude of this cannot be understated, for comparison, QE3 only removed USD 280bn in its first year in 2012. Since then, Fed purchases continue at a monthly pace of ~40 billion. Recent Fed minutes show no reason to expect a tapering of purchases in the near-term, though considerable economic improvement could change the narrative.

QE4: Monthly Breakdown

Sources: J.P. Morgan, FRBNY. Data as of December 31, 2020  

Theme 2: TBA Dollar Rolls

Fed MBS purchases helped TBA dollar rolls become special again after having been weighed down by worsening fundamentals in recent years. As a recap, special means that the monthly return generated by rolling TBA contracts is higher than from actually owning the underlying MBS. Since Fed purchases help remove the fastest prepaying MBS from the private market, the carry generated from rolling TBA contracts improves. This dynamic is limited to the coupons that the Fed is actually buying, which are production coupons (currently 1.5, 2, and 2.5%). Fed purchases should continue to lend a supporting hand to dollar rolls in 2021; however, with supply elevated, the level of lower coupon TBA dollar roll specialness could decline.

Carry on TBA: Production vs. higher coupons

Sources: J.P. Morgan. Data as of December 31, 2020. TBA = To-be-announced

Theme 3: Record low mortgage rates = fast prepay speeds

Lower U.S. Treasury yields and record Fed MBS purchases helped mortgage rates decrease through 2020, dipping below 3% for the first time in history. Alongside this came productivity and capacity increases in the mortgage business, which meant a more efficient refinance process. This lead to prepayment speeds increasing, especially for higher rate borrowers with more incentive to refinance. Absent a shock higher in Treasury yields, mortgage rates should continue to drift lower as lenders increasingly compete on pricing. With >80% of the MBS universe still eligible to refinance at current rate levels, prepay speeds should remain elevated well into 2021. 

30 Year Mortgage Rate / Prepayment Speed

Sources: J.P. Morgan, eMBS, Freddie Mac 30yr Survey Rate. Data as of December 30, 2020

Theme 4: CARES Act implements forbearance

Economic hardship from the pandemic lead the government to implement a national mortgage forbearance program. Originally, this was a concern for mortgage investors as the lack of clarity around how borrowers would exit forbearance meant that large prepayments could potentially occur. Fortunately, the implemented process for forbearance exit alleviated both investor and borrower concerns. While forbearance rates have declined, they should remain elevated in 2021 as economic hardship persists. For mortgage investors, it will be crucial to monitor when & how borrowers exit forbearance.  

Pct. of Servicing Book in Forbearance in MBA Survey       

Sources: J.P. Morgan, Mortgage Banker Association (MBA). Data as of December 21, 2020

Theme 5: Record Bank Demand 

Record deposit growth lead to large increases in MBS on bank balance sheets. This was a positive technical that drove MBS valuations higher throughout 2020. While 2020’s purchase amounts will be tough to replicate, bank demand for MBS should remain buoyed with their cash levels remaining elevated heading into 2021. 

Change in Bank Holdings Agency MBS

Sources: J.P. Morgan, Federal Reserve H.8. Data through December 31, 2020.

Theme 6: “Fed coupons vs. Non-Fed Coupons”

Fed purchases being limited to lower coupons and prepay speeds being the fastest in higher coupons weighed on higher coupons all year. Their performance divergence from lower coupons was massive as a result. For higher coupons to have a fighting chance in 2021, they will need to see prepayment speeds decline and/or Treasury yields to increase. Meanwhile, lower coupons grew rapidly from an outstanding balance of USD 200 billion to USD 1.5 trillion in 2020, we expect this trend to persist in 2021 as mortgage rates remain low and refinance activity continues. As with most things in MBS, a move in interest rates would be the primary catalyst for a change to this trend.

Excess Returns by Coupon

Sources: J.P. Morgan, Bloomberg Barclays Index Excess Returns. Data through December 31, 2020

Outstanding Balance by Coupon Sources: J.P. Morgan. Data through November 30, 2020

While much remains uncertain about 2021, revisiting the major 2020 themes that influenced MBS may prove a useful place to start as most of them remain in place in 2021. MBS is never an easy asset class to wrap one’s head around but understanding the fundamental and technical factors at play helps demystify it and may provide a valuable framework for navigating the coming year.