Shifts in the mortgage landscape are creating a compelling opportunity in GNMAs, which currently offer attractive relative value.
- Reduced prepayment risk: The magnitude of the rise in mortgage rates has eliminated the financial incentive to refinance for nearly all homeowners, leading to slowing prepayments and fully extended MBS durations.
- Wider spreads, more yield: Reduced prepayment risk (aka negative convexity) has made GNMA MBS more Treasury-like, trading simply on duration. Meanwhile, the spread over Treasuries is larger than it was a year ago.
- Favorable shift in supply/demand balance: Once quantitative tightening is fully implemented, the Federal Reserve will be largely out of the business of buying MBS. Despite this reduced Fed demand, lower MBS supply from the housing slowdown should lead to a more favorable supply/demand outlook.
Surging mortgage rates have reduced extension and contraction risk
Homeowners had several opportunities over the past decade to refinance into lower rates, and many did. Most recently, borrowers were able to lock in 30-year fixed mortgage rates below 3%, driving a massive refi wave in 2020 and 2021. But with the dramatic rise in mortgage rates this year, that window shut, and many homeowners are now sitting happily with mortgage rates significantly lower than current prevailing rates (Fig. 1).
As of June 30, 2022. Source: Freddie Mac, Bloomberg Index Services Limited, Voya Investment Management. Convexity data reflects the Bloomberg U.S. GNMA 30-Year Index.
With current mortgage rates much higher than the average homeowner’s rate, a change in rates up or down won’t make much difference to the refi incentive and therefore shouldn’t impact mortgage-backed security (MBS) durations.
For homeowners, a move higher in rates would not make refinancing any less attractive, while a move lower in rates would need to be substantial to bring back the financial incentive. Said another way, the “option” homeowners have to “call” their mortgage is deep out of the money, and negative convexity is near zero, reducing a source of potential volatility in MBS.1
Prepayments are actually a good thing now
By definition, when the refi option is out of the money, GNMAs trade at a discount to par (Fig. 2). The implication is that in addition to reduced extension/contraction risk— collectively known as prepayment risk, or negative convexity—there is a new opportunity for active managers to add value.
As of June 30, 2022. Source: Bloomberg Index Services Limited. Past performance is no guarantee of future results.
In a premium environment, a manager’s task is to find mortgages they believe will prepay slower than what the market expects. In today’s discount environment, we’re looking for mortgages we believe will prepay faster. The current strength of labor market coupled with aggressive home price appreciation (HPA) has made homeowners more mobile, driving turnover activities that prompt prepayments:
- Over the last few years, Covid and supply-chain disruptions have made buying and selling a home more challenging, and pent-up demand to upsize, downsize, or simply move to a new location has been building.
- Adoption of remote work options is driving migration from urban to rural areas and from high-cost states to low-cost states. Mortgage rates may not matter much to those with the flexibility to work from home, as they can sell their high-priced home in a high-cost area and buy a bigger, nicer house for the same price in a lower-cost area.
- Elevated HPA has led to more home equity, and a cash-out refi gives homeowners a way to access some of that equity. Although it is unrealistic to assume homeowners with rock bottom mortgage rates will choose this method, for homeowners with a mortgage rate only slightly lower than prevailing rates, it may be a relatively attractive option.
The key for active managers is to identify where these turnover opportunities exist and perform the proper due diligence to achieve higher prepayments versus the benchmark in a discount environment. As we say of the securitized asset class, “Every CUSIP has a story.”
Wider spreads and more yield
While it’s an oversimplification, GNMA MBS can be thought of as Treasuries (guaranteed by the U.S. government) that are callable (i.e., refinanced at a lower rate). Because that call risk has diminished significantly, GNMAs are more comparable to Treasuries, trading primarily on duration. Yet GNMAs continue to command a risk premium over Treasuries. That risk premium has actually widened over the past 12 months to levels above the historical average (Fig. 3).
As of June 30, 2022. Source: Bloomberg Index Services Limited, Voya Investment Management. Based on the Bloomberg U.S. GNMA 30-Year Index.
Add in the overall shift higher in interest rates along with increased term premium created by duration extension, and all-in yields for GNMAs (as measured by yield to worst2) are now the highest they’ve been in over 10 years.
Favorable shift in supply/demand balance
The Fed’s quantitative easing program—involving large purchases of U.S. Treasuries and agency MBS—has been a significant source of demand for GNMAs. As the Fed has shifted to quantitative tightening, support for agency MBS has been gradually reduced. Starting June 1, 2022, the Fed stopped adding to its balance sheet on both a gross and net basis, up to prescribed caps. While this tightening (also referred to as “balance sheet runoff”) will eliminate a huge source of MBS demand, it is important to consider the supply side of the equation as well.
The red-hot housing market of 2020 and 2021 has cooled. Home sales are well off their peak and are expected to remain subdued, as indicated by the MBA purchase index (Fig. 4). This sharp decline in housing market activity is expected to meaningfully reduce the new supply of mortgages. Combined with the drop-off in refi activity, the expectation is that future agency MBS issuance will be significantly lower than 2020–21 levels. As a result, we believe the supply/demand balance for agency MBS is likely to be more favorable going forward than it has been in years past.
May 31, 2022. Source: National Association of Realtors, Mortgage Bankers Association of America, Voya Investment Management.
Amid shifts in the mortgage landscape, we see a compelling opportunity in GNMA MBS today, given:
- Diminished contraction and extension risk
- An above-average yield spread to Treasuries
- A likely reduction in supply, more than offsetting reduced Fed demand
- Deep discounts to par, creating new opportunities for active managers
Related resources: Voya GNMA Income Fund
All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. As Interest Rates rise, bond prices fall, reducing the value of the Fund's share price. To the extent that the Fund invests in asset-backed, Mortgage-Backed or Mortgage-Related Securities, its exposure to prepayment and extension risks may be greater than investments in other fixed-income securities. While the Fund invests in securities guaranteed by the U.S. Government as to timely payments of interest and principal, the Fund shares are Not Insured or Guaranteed. Other risks of the Fund include but are not limited to: Credit Risks; Extension Risks; Other Investment Companies' Risks; Prepayment Risks; U.S. Government Securities and Obligations Risks; and Securities Lending Risks. Investors should consult the Fund's Prospectus and Statement of Additional Information for a more detailed discussion of the Fund's risks.