Impact of Rising Rates on the Mortgage Market

Interest rates have risen sharply since the start of the year with the 10-year Treasury yield up more than 70bps as of March 12 and the Freddie Mac survey rate back up over 3%. Higher rates generally hurt returns on (unhedged) fixed-income investments. However, mortgage-backed securities (MBS) interact with rates in more complex ways than do most other asset classes. For example, hedge rebalancing activity in the mortgage market can magnify rate movements themselves, sending rates higher in a sharp selloff (or lower in a sharp rally). But higher rates can also have a positive influence on MBS supply technicals, fundamentals (prepayments), and relative value. We explore these topics in more detail below.

Re-Emergence of “Convexity Event” Risk

Mortgage-backed securities are generally negatively convex, meaning that durations usually extend when rates rise and shorten when rates fall. This behavior is in contrast with most other fixed-income asset classes which are positively convex. Some holders of mortgage risk routinely hedge some or most of the interest rate risk (duration) in their portfolios. The most active hedgers include the government sponsored enterprises (GSEs), mortgage hedge funds, real estate investment trusts, and mortgage servicers. Mortgage market participants use a variety of mechanisms for hedging duration including selling Treasuries and paying fixed on swaps. When rates move significantly, these investors must rebalance their hedges, shedding duration when rates sell off and adding duration when rates rally.

When rates move sharply higher, the sudden increase in the volume of mortgage hedging flows (e.g., Treasury sales) can create a reinforcing feedback loop that leads to a further increase in interest rates (and a potential widening of swap spreads), which in turn leads to a further increase in mortgage hedging flows, and so on. This phenomenon is called a “convexity event” and is feared by fixed-income investors because of its potential to erode performance. The Taper Tantrum of 2013 is an example of a major convexity event in the post-financial-crisis period. The event was triggered when Federal Reserve (Fed) Chairman Ben Bernanke signaled an earlier-than-anticipated tapering of asset purchases in his testimony to Congress on May 22, 2013.

This year’s big rate moves have led to renewed discussion on the likelihood of another convexity event. But not all rate moves result in a market-moving volume of mortgage convexity hedging flows. There are many variables which influence the extent of convexity hedging flows, but two of the key drivers are (1) the convexity of the mortgage universe at current rate levels and (2) the share of the mortgage universe in the hands of investors who actively hedge their mortgage exposure.

The mortgage index has extended considerably since year-end 2020—FactSet model duration on the Fannie Mae 30-year fixed-rate universe (FN30s) has extended by nearly two years since year-end 2020 (Figure 1, left panel). But the universe is still quite negatively convex at current rate levels (Figure 1, right panel). So, a modest rise in rates from here will lead to significant further extension of the mortgage universe, based on our model.

But the distribution of mortgage risk across investor types also matters. Much less of the mortgage universe is in the hands of active hedgers today than was the case before the global financial crisis (GFC). The Fed, which does not hedge, currently owns close to one-third of the agency MBS universe (see Figure 2). Conversely, the GSEs, which do actively hedge, have shrunk their portfolios substantially since the GFC. Therefore, a sharp rate move is less likely to trigger a convexity event today than was the case 10 years ago.

Improving Supply Technicals

The COVID-19 pandemic triggered the Fed’s re-entry into the mortgage market in a big way, helping to create strong demand-side technicals. The Fed is currently buying $40 billion of agency mortgage-backed securities per month and is likely to continue to do so for some time to come. Domestic bank demand has also been robust—banks added around $500 billion of agency MBS to their holdings in 2020 and have continued to buy MBS at a rapid pace so far this year.

Meanwhile, the technicals picture on the supply side has been less supportive. Since the start of the pandemic, numerous factors have helped to boost MBS net issuance, including strong home price appreciation (HPA), a surge in demand for single-family homes, and an increase in cashout activity.

But higher rates can have a beneficial impact on supply technicals. Rising rates directly reduce housing affordability, which in turn places downward pressure on new home sales, a key driver of MBS net supply. Figure 3 illustrates the inverse relationship between the primary mortgage rate and new home sales. Moreover, reduced demand for housing should in turn lead to a decline in HPA. Lower HPA can eventually help to reduce the pace of cashout refinancing (refi) activity, helping to moderate net supply in the longer term.

Lower Prepayment Risk

With most of the mortgage universe trading at a steep premium, prepayment risk has been top of mind for many months. The primary mortgage rate fell throughout 2020, reaching record lows and triggering a major refi wave. Aggregate speeds on Fannie Mae 30-yr fixed-rate collateral reached 37% CPR (conditional prepayment rate) in October 2020, the highest level since 2003. COVID lockdowns do not appear to have materially hampered borrowers’ ability to refinance existing mortgages or purchase new homes. Property inspection waivers, electronic income and asset verification, and other flexibilities and innovations have kept origination volumes elevated.

A modest increase in interest rates can provide a welcome respite from persistent refi activity. Slower prepayments boost realized yields on mortgage-backed securities purchased at a premium. With the primary mortgage rate back above 3%, around half of the mortgage universe is no longer refinanceable (which we define as a rate incentive of 50bps or more) (see Figure 4). At current rate levels, conventional 30-yr 1.5s and 2.0s are out of the money and 2.5s are generally just outside of the refinanceable range. As such we should begin to see a slowdown in refi speeds in the coming months if rates stay here or rise further.

Based on our model, 2.5s are the cuspiest coupon at current rate levels (versus 2.0s at year-end 2020), and should slow the most if rates rise from here (see Figure 5). But the actual speed impact on any given mortgage pool depends on numerous factors including the current characteristics of the underlying collateral, loan seasoning, and cumulative past exposure to refi opportunities.

Tightening Pressure on Spreads

Option-adjusted spread (OAS) levels on mortgage-backed securities are influenced by numerous factors including supply and demand technicals, the evolution of the collateral characteristics, the macro backdrop, and regulatory changes. As such, it can be hard to separate out the impact of any individual factor on mortgage spreads.

But all else being equal, mortgage spreads tend to move directionally with rates, i.e., spreads tend to widen when rates rally and narrow when rates sell off. One reason for this directionality is the change in prepayment model risk, i.e., the likelihood that projected speeds differ from realized speeds, when rates move. When rates rally, model risk rises as refi activity picks up and speeds become more volatile and harder to predict. Investors require additional return to compensate for the increased uncertainty, leading to a widening of OAS. Conversely, when rates sell off, model risk declines as refi activity subsides and speeds retreat closer to baseline levels, which are generally easier to predict. Therefore, OAS tends to narrow when rates sell off.

Conclusion

Rising rates have a silver lining for mortgage investors. To be sure, a sharp increase in rates can increase the likelihood of a convexity event occurring. But a convexity event is less likely today than in the past, given the increase in the Fed’s holdings of MBS and the reduction in the GSEs’ portfolios. Moreover, a modest rate increase can place downward pressure on MBS net supply, lower prepayment risk, and narrow mortgage spreads. When making investment decisions, MBS investors must consider the multi-dimensional impact of rate movements on mortgage collateral as well as the complex interactions between mortgage market hedging activity and rates themselves.