Jim Reber: Mortgage Mélange

I’m going out on a limb here, but one day, mortgage rates will not only quit rising; they will actually begin to fall. When that happens, community bank bond portfolio managers will have to deal with a host of factors (most of them positive) they haven’t seen in a while, if ever. 

The sheer scale of the Fed’s tightening has produced a number of mortgage-backed securities (MBS) that appear to be custom-built for a flat or falling rate environment. So, just in time for Thanksgiving, let’s take a stroll around the MBS supermarket to see what’s on your favorite brokers’ shelves. 

Crowd pleasers

This column will focus on 15-year MBS and alternatives, as those are clearly the preference of depositories. You might find the above subheading a bit ironic, as there are precious few 15-year pools being created now. Between record-high housing prices and loan rates we haven’t seen since 2007, the average P&I payment has increased by 67% for new purchases in just 18 months. 

That’s taken a lot of 15-year borrowers out of the market. In fact, it’s been more than a year since there has been a net growth in that sector; recent production levels are down over 90% from the peak in April 2021. 

Despite the relative lack of supply, yield spreads on 15-year paper are historically wide, even though prepayment risk is low. But why are yields still attractive? Several probably temporary factors: lack of depository buyers, liquidation of several notable failed bank portfolios (which had very few short MBS pools), the debt ceiling showdown and the Fed’s winding down of its portfolio. 

A reasonable case can be made that spreads will begin to narrow, which sets up the 15-year sector to outperform others, mortgage-related or otherwise.

Main course

Some of you will say you already have enough (too much?) exposure to 15-year pools. What’s the next best option? 

For the past few months, mortgage strategists from Stifel have been suggesting hybrid adjustable rate mortgage (ARM) pools. These securities have a “fixed-to-float” structure, and the investor can pick the term of fixed period from three to 10 years. With the inverted yield curve, the shorter “roll date” securities have higher initial yields and lower effective durations, both of which bargain hunters seek. Many other measures of relative value favor hybrids over straight pass-throughs: lower prices, wider spreads, better total returns. About the only metric that would favor the MBS over the hybrid is liquidity, which is a conversation worth having with your brokers. 

Another favorite entrée is a well-structured collateralized mortgage obligation (CMO). One of the benefits of a CMO over the “collateral,” which is the MBS used to build out the various classes of an issue, is that an investor can choose tranches with specific coupons, prices, cash flows and principal payment windows that better fit the community bank’s needs. 

Finally, while supplies of these MBS alternatives are limited, brokers should be able to locate some offerings of both given reasonable parameters. This includes securities bearing the GNMA label, which many investors like for the full-faith-and-credit, 0% risk-weighting feature. 

Just desserts

The final item on this month’s menu has been offered before (see "Collateral Advantage" from March 2023), but now with a few additional ingredients. Rarely, if ever, have such a wide range of pass-through rates on mortgage securities been available simultaneously. This gives a portfolio manager a delectable set of options. About the only selections that are not available at the moment are premium MBS; par (100.00) and discount pools are what the market is serving. 

The good news is that discount pools can be found at virtually any price. As of this writing, 15-year 4.0% pools are priced with a 96 handle, while 15-year 2.0%s are in the 86 range. (Disclosure: Be aware that the lower the coupon, the tighter the yield spreads.) 

You can also take this one step further with the CMO market. It’s possible to locate a given tranche with a significantly discounted price, even though the collateral is more “current coupon.” This could potentially create an opportunity for some improved cash flow, if and when rates begin to recede, as the newer loans with 7%-plus borrowers’ rates will be the most responsive to refinance opportunities. In epicurean terms, it’s “tastes great, less filling.”

There you have an enticing bill of fare for November. Straight pass-throughs with wide yield spreads, hybrid ARMs with great total return characteristics and well-built CMOs can create a veritable smörgåsbord for your community bank’s bond portfolio.