As interest rates rose in the U.S. over the course of 2018, homeowners had less incentive to refinance their mortgages, and prepayments in agency mortgage-backed securities (MBS) declined. However, we think the market is now underestimating what prepayment speeds on lower coupon mortgages will be going forward. In our view, a combination of positive macroeconomic factors is likely to keep prepayment speeds higher than the market’s projections, which in turn could benefit deeply discounted and lower coupon agency MBS.
As a result, high quality agency MBS may offer attractive opportunities for investors.
How do prepayments affect agency MBS?
Mortgage borrowers in the U.S. typically have the option to prepay their loans at any time. Borrowers on fixed-rate mortgages tend to prepay more quickly when interest rates fall because many refinance at lower rates; conversely, prepayments on fixed-rate mortgages tend to slow when interest rates rise and refinancing declines. However, borrowers also prepay their mortgages for other reasons, what we call a “natural rate” of prepayment, or turnover: Families move, for example, and they can also change homes for personal reasons that aren’t a function of interest rates.
For investors in discounted agency MBS (bonds priced below $100), any increase in mortgage prepayments would be a positive because the investor would immediately realize the difference between the current bond price and $100 on the amount that was prepaid.
U.S. economic factors
Looking ahead, we believe two main macroeconomic factors stemming from U.S. economic strength will likely spur higher prepayments on agency MBS. The key improvements we see are:
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Job turnover and mobility are increasing.
- Labor market strength is driving higher employment turnover. Average tenure with a current employer peaked at 4.6 years in 2012 and has since fallen to 4.2 years, according to the Bureau of Labor Statistics. For comparison, job tenure fell to 3.5 years in the economic boom of the early 2000s. Higher employment turnover typically leads to higher mobility as people move in search of better jobs, which is an important factor in prepayment levels.
- Mobility has started to increase among homeowners, according to U.S. census data, after declining for several years following the financial crisis. If mobility increases toward pre-crisis levels, this should drive faster ongoing prepayments.
