Possibly the best mortgage bonds to buy right now are the ones the Federal Reserve buys, as the securities could benefit the most if macro-optimism wears off.
So far this year, some investors have more hope of an economic recovery as a new US stimulus package is rolled out. According to a recent report from Bank of America, markets are looking for positive macro signs that could cause the Fed to curtail its direct purchases of mortgage bonds.
A slowdown in its buying by the central bank would hurt the demand for 30-year uniform mortgage-backed securities with coupons of 2% and 2.5%, which it tends to buy. Rejuvenation concerns are part of why these securities have outperformed government bonds this year by just 0.05% and 0.06%, and far worse than mortgage bonds with coupons of 3% and 3.5%. These higher coupon bonds have generated excess returns of 0.75% and 0.65%, respectively.
However, investor optimism about the recovery may not continue. With regard to bond yield projections, there is consensus that 10-year treasury yields will decrease by approximately 0.1 percentage points by the end of the quarter and the difference between 10-year and 2-year US government bond yields will decrease year over year decrease by 0.16% will same time frame.
Either move would mean that mortgage investors are likely to be more concerned about the pace of the economic recovery in the coming weeks. This would help lower coupon mortgage bonds and damage higher coupon securities.
"With higher coupons, the steeper yield curve encounters headwinds, the call risk is high and there is no Fed backstop," said Randy Ahlgren, director of Wells Fargo. "It's hard to see the higher coupons continue to outperform."
Both 3% and 3.5% unified MBS in the last prepayment report were paid at 40.2 CPR, which means that at the current pace, just over 40% of the remaining principal of the bonds is prepaid annually at face value, potentially impacting performance . Investors who bought these bonds may have hoped for a slowdown in prepayments, but they may be disappointed.
The mortgage lending industry has been rapidly expanding its application processing capacity in 2020, which means that even if interest rates rise or remain stable, they may continue to seek to keep mortgage rates low to keep their pipelines full. The weighted average coupon for mortgages bundled in 3% bonds is 3.73% and for 3.5% securities it is 4.12%. The borrowers still have a sufficient incentive to refinance with 30-year mortgage interest rates of 2.73%.