Mortgage investors bracing for Fed’s taper may be disappointed

The best mortgage bonds to buy now may be the ones the Federal Reserve is purchasing, because the securities might benefit the most if macro optimism fades.

So far this year, some investors have been growing more hopeful about an economic recovery as a new U.S. stimulus package is rolled out. This has markets looking for any positive macro signs that may translate to the Fed tapering its direct purchases of mortgage bonds, according to a recent Bank of America report.

A slowdown in central bank buying would hurt demand for the 30-year uniform mortgage-backed securities with 2% and 2.5% coupons that it tends to buy. Concerns about tapering are part of why those securities have generated excess returns over Treasuries of just 0.05% and 0.06% this year, performing far worse than mortgage bonds with 3% and 3.5% coupons. Those higher-coupon bonds have generated excess returns of 0.75% and 0.65%, respectively.

But investor optimism about recovery may not last. Looking at bond yield forecasts, consensus is for the 10-year Treasury yield to fall about 0.1 percentage point by the end of the quarter, and for the difference between 10-year and 2-year U.S. Treasury yields to narrow by 0.16% over the same time frame.

Both of those moves would imply that mortgage investors are likely to grow more concerned about the pace of economic recovery in the coming weeks. That would help lower-coupon mortgage bonds and hurt higher-coupon securities.

“For higher coupons, the yield curve steepening is running into some headwinds, call risk is high and there’s no Fed backstop,” said Randy Ahlgren, a director at Wells Fargo. “It’s tough to see the higher coupons continue to outperform.”

Both 3% and 3.5% uniform MBS in the latest prepayment report paid at 40.2 CPR, meaning that at the current pace just over 40% of the remaining principal balance on the bonds will be prepaid annually at par, potentially hurting performance. Investors that have bought these bonds may have been hoping for prepayments to slow, but they may be disappointed.

The mortgage lending industry added application processing capacity at a rapid pace in 2020, meaning that even if rates rise or stay steady, they may still look to keep mortgage rates low to keep their pipelines full. The weighted average coupon of the mortgages bundled into 3% bonds is 3.73%, and for 3.5% securities it’s 4.12%. The borrowers here still have ample incentive to refinance with 30-year mortgage lending rates at 2.73%.