Mortgage investors’ concern about prepayment speeds may increase as a renewed U.S. rate rally helps push the U.S. MBS index duration down to its lowest level since March.
Duration, a measure of a security’s price sensitivity to a change in interest rates, will drop on the assumption that principal payments on that bond will be received earlier than previously expected. That’s what happens with mortgage-backed securities as rates decline since homeowners are then expected to increasingly refinance into lower mortgage rates and pay off their previous loans.
The Bloomberg Barclays U.S. MBS index duration now sits at 4.15 years, down from a recent high of 4.47 on April 22, though still above the year-to-date low of 3.84 seen on March 27, according to data compiled by Bloomberg. Its trailing one-year average is 4.94 years.
While prepayment speed have shown increases of over 20% in the last two monthly reports, this was thought to be transitory as rates had risen throughout much of April. Now however, a renewed rally that has seen the U.S. 10Y yield drop to its lowest level since March 29, and the Freddie Mac 30-year mortgage rate fall for the first time in five weeks, may continue to spark refinancings if sustained.
The most recent forecast from JPMorgan MBS analysts calls for a 15% increase in prepayment speeds for May, though with upside risk to come in at 20%.
There’s a bright side to all of this for those mortgage investors already long specified pools designed to protect from a spike in refinancings. A sustained rate rally may help those securities hold or even increase in price. This is especially so for 30-year conventional 4 and 4.5% coupons, as that is where the most risk for a surge in prepayments is thought to be concentrated.