BR is Bullish on Resi Credit: The U.S. residential mortgage market is $14T. When a mortgage is out-of-the-money, the loan trades below par and the prepayment rate is ~3% CPR which means only 3% pre-pay per annum (i.e., owner moves, extra cash flow, death), a low prepayment rate. When mortgage rate fall, homeowner who are in-the-money by 75bs are likely to refinance, CPR jumps to 20%+ given homeowners seek to lower their monthly payment. It’s wonderful news for homeowners, but for those who own premium coupon MBS they are subject to negative convexity. Convexity measures the sensitivity of a bond’s price to changes in interest rates. Bonds with positive convexity benefit commensurately to a decline in rates as future cash flows are discounted at a lower rate, making them more valuable. MBS on the other hand have negative convex when the price approaches par as the investment doesn’t increase as much from this inflection point due to prepayment risk rising as the bondholder loses the opportunity to earn the higher interest payments and then must reinvest at lower rates.
The bar chart below shows the rate distribution for the mortgage universe. As the mortgage rate is now 6.1%, mortgages >6.5% are highly susceptible to early pre-payment. MBS between 5% – 6%, might see prepayments inch up marginally from 3% CPR to 4% as these slightly out-of-the-money homeowners who have felt trapped, now have more flexibility to move since the cost to do so is marginalized. Note that in the U.S., 30-year fixed rate mortgages are priced at spread to 10-year UST (not SOFR or Fed Funds); I expect the 10-year UST rates will decline less than the front end of the curve as the yield curve steepens as the Fed cuts rates. New home sales will benefit in this lower rate environment as will existing homes sales.
Be Bullish: lower mortgage rates are net-positive for homeowners/residential credit, home builders, building materials, and mortgage originators. |
