As interest rates rose in the U.S. over the course of 2018, homeowners had less incentive to refinance their mortgages, and prepayments in agency mortgage-backed securities (MBS) declined. However, we think the market is now underestimating what prepayment speeds on lower coupon mortgages will be going forward. In our view, a combination of positive macroeconomic factors is likely to keep prepayment speeds higher than the market’s projections, which in turn could benefit deeply discounted and lower coupon agency MBS.
As a result, high quality agency MBS may offer attractive opportunities for investors.
How do prepayments affect agency MBS?
Mortgage borrowers in the U.S. typically have the option to prepay their loans at any time. Borrowers on fixed-rate mortgages tend to prepay more quickly when interest rates fall because many refinance at lower rates; conversely, prepayments on fixed-rate mortgages tend to slow when interest rates rise and refinancing declines. However, borrowers also prepay their mortgages for other reasons, what we call a “natural rate” of prepayment, or turnover: Families move, for example, and they can also change homes for personal reasons that aren’t a function of interest rates.
For investors in discounted agency MBS (bonds priced below $100), any increase in mortgage prepayments would be a positive because the investor would immediately realize the difference between the current bond price and $100 on the amount that was prepaid.
U.S. economic factors
Looking ahead, we believe two main macroeconomic factors stemming from U.S. economic strength will likely spur higher prepayments on agency MBS. The key improvements we see are:
- Job turnover and mobility are increasing.
- Labor market strength is driving higher employment turnover. Average tenure with a current employer peaked at 4.6 years in 2012 and has since fallen to 4.2 years, according to the Bureau of Labor Statistics. For comparison, job tenure fell to 3.5 years in the economic boom of the early 2000s. Higher employment turnover typically leads to higher mobility as people move in search of better jobs, which is an important factor in prepayment levels.
- Mobility has started to increase among homeowners, according to U.S. census data, after declining for several years following the financial crisis. If mobility increases toward pre-crisis levels, this should drive faster ongoing prepayments.
- Home equity is rising.
- The amount of equity that borrowers have in their homes has reached its highest level since the financial crisis, based on data from the Federal Reserve through third quarter 2018. This has two effects, both of which will likely drive prepayments higher: First, many households that delayed upgrading to better homes after the financial crisis can now afford to “trade up.” In addition, more homeowners can tap their home equity with cash-out refinancing. Tight lending conditions have kept cash-outs low, but as rates continue to rise, many lenders may loosen their lending requirements.
Investment implications for agency MBS
Improvements in the U.S. labor markets and rising home prices are both supportive of higher prepayments in agency mortgages. Despite uncertainty around what the Federal Reserve will do regarding interest rates, we believe rising home equity and increasing mobility will drive better-than-expected cashflows in discounted/lower coupon agency MBS and create potential opportunities for investors in 2019.
For more on our economic and investment views, please see our outlook for the year ahead, “Synching Lower.”
Munish Gupta is a portfolio manager at PIMCO, focusing on agency mortgage-backed securities and structured products. Ryan Murphy is a mortgage and credit strategist.