So far this week trading has been dictated by the outlook of coronavirus cases and as we’ve mentioned in the past, with the outlook in New York improving at the margins, New York-based traders are often reacting with risk-on enthusiasm. We’re not, however, as sanguine about the outlook as other regions seem more than ready to take over as the coronavirus hotspot as New York case counts plateau and start to decline. Treasuries meanwhile continue to bask in the afterglow of the Fed’s multitude of programs meant to keep all manner of markets liquid and functioning. And with those programs and policy rates not going anywhere anytime soon investors are comfortable holding 0-handle Treasuries. The 10-year Treasury yield stands at 0.67% which is near the lower end of the recent range of 0.56% to 0.89%. The stability of yields is notable but if good news accelerates on the virus front, including some tentative vaccine developments, it’s likely that yields would find support at 1.20%, from whence the flight-to-safety rally commenced in mid-March.
We mentioned that recent trading has been driven by the outlook of coronavirus cases with little economic news to distract from that focus. That does change a bit this morning with the March Retail Sales Report. So far the weekly jobless claims numbers have been the only economic data series that has fully reflected the horrific impact of the deep-freeze put on the economy through social distancing. That is until now. The March Retail Sales Report saw sales plunge –8.7% versus –0.4% in February. The monthly decline is by far the worst monthly decline in the history of the series which dates back to 1990. The previous low print was –3.9% in November 2008, during the depths of the financial crisis. What’s more with many locales not instituting shelter-in-place policies until late March or early April the April report will probably eclipse March’s to the downside. Treasury prices were trading higher prior to the report and the rally has been boosted even though the ugly numbers mostly matched the awful expectations.
Meanwhile, In its first World Economic Outlook report since the spread of the coronavirus and subsequent freezing of major economies, the IMF estimated that global gross domestic product will shrink 3% this year. That compares to a January projection of 3.3% expansion and would likely mark the deepest dive since the Great Depression. It would also dwarf the 0.1% contraction of 2009 amid the financial crisis. In the U.S., GDP is expected to contract 5.9%, compared with a 2% expansion in its last global outlook in January. It may grow 4.7% next year, the IMF said. The euro area will probably shrink 7.5% in 2020 and expand 4.7% in 2021. The fund sees advanced economies shrinking the most, contracting 6.1% while emerging-market and developing economies will see a 1% drop. Growth in China and India will decelerate but their economies will still manage to expand 1.2% and 1.9% respectively, the IMF said.
A Couple Ways to Play the Coming Prepayment Rollercoaster
We mentioned last week that with the forbearance program for mortgage debtors in the recently passed CARES Act, mortgage prepayments this year could see a period of quiet then followed by faster speeds when the forbearance programs expire. That expected pattern leads to two ways to approach mortgage investments this year.
As mentioned, the CARES Act added a new forbearance program for mortgage debtors struggling financially from the fallout of the virus. Forbearance is a temporary suspension of scheduled mortgage payments that borrowers are required to eventually make up. During forbearance, servicers advance principal & interest payments on behalf of the borrower. The law provides for up to a 6 month deferral period followed by another 6 month period, if deemed necessary. Loans in forbearance jumped from 0.25% on March 2 to 3.74% on April 5. On a weekly basis, home loans backed by Ginnie Mae showed the largest growth with the share in forbearance climbing 1.58 percentage points to 5.89%. Loans backed by Fannie and Freddie increased to 2.44% from 1.69%.
During the forbearance period involuntary prepayments (foreclosure, etc.) should slow and voluntary prepays as well with the economic uncertainty of the virus hanging over the country. After the forbearance program runs its course, a delinquency buyout results in an involuntary prepayment if the borrower cannot repay the missed payments in a timely manner & the servicer determines that the loan needs to be modified.
The earliest we’re likely to see these involuntary prepayments is November which assumes a borrower throws in the towel after the initial 6 month deferral period. In all likelihood, however, there will be many more borrowers who apply for the second 6 month deferral period and thus delaying an involuntary prepayment until this time next year.
On its face there are a couple different ways to play the coming prepayment pattern:
- One way is to look for larger coupon, higher premium pools with a large and diverse pool size (possibly GNMA focused). With the higher premium and expected slowing in prepayments over the next year, book yields should lift accordingly. After six months and/or certainly a year, expect prepayments to begin accelerating. As that time approaches it may be prudent to consider trading down in coupon or other product to avoid a possible faster prepay and lower book yield scenario.
- Another way to play this outlook is less management-intensive and that is to just look for pools with the lowest coupons and more modest premiums; thus, avoiding to a degree the whole upcoming prepayment rollercoaster and the resultant impact to book yields. Of course, in both scenarios, one might want to accelerate premium amortization during the quiet period of prepayments, positioning the bond with a lower book price and less susceptible to swings in yields when involuntary prepayments accelerate.
In any event, the unfolding situation does provide the mortgage investor with options to consider. If you want to explore those options and what may be best given your existing portfolio please contact your CenterState Bank representative.
Agency Indications — FNMA / FHLMC Callable Rates
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