- The duration of indexes of mortgage-backed securities (MBS) has extended drastically over the last year. Understanding duration dynamics can be critical for investors managing portfolios against MBS indexes.
- A factor-based duration analysis revealed that an MBS index’s duration extension could be attributed to six main, competing factors.
- By managing against MBS indexes from a duration perspective, investors can gain more insight into the MBS market and the characteristics of MBS models.
Mortgage-backed securities (MBS) constitute a significant portion of fixed-income indexes. Managing MBS portfolios against these indexes depends heavily on an understanding of the dynamics of MBS duration, especially amid the current volatile market environment. A factor-based duration analysis can provide a framework for managing against MBS indexes, which showed dramatic duration extension attributable to six main, competing factors over the last year.
MBS Index’s Duration Extended Drastically in the Last Year
Index duration is calculated and aggregated based on all the eligible generic cohorts of 30-year agency MBS at month-end. Sources: Fannie Mae, Freddie Mac, MSCI Agency Prepayment Model Version 2.0, MSCI Two-Factor Interest Rate Model
As of June 30, 2021, the year-over-year duration of MBS indexes extended by 2.6 years, although the primary 30-year mortgage interest rate was about the same at the end of June for both 2020 and 2021 — near 3%. We identified six main factors for this and sequentially assessed their effects, similar to a typical “sequencing” methodology for performance attribution, to illustrate the attribution of this duration extension.1
- Curve Steepening: The yield curve has bear-steepened significantly since September 2020. The 10-year yield also has risen back to pre-pandemic levels, near 1.5%, while the two-year yield has stayed flat. This has driven the forward mortgage-rate projection higher, which has led to a slower prepayment projection and longer duration.
Yield Curve Bear-Steepened Since September 2020, Leading to Longer MBS Duration
- Current-Coupon (CC) Spread: CC spread can be interpreted as the overall MBS yield relative to the entire swap curve.2 A negative spread usually indicates rich MBS valuation relative to the rate market, as was seen during the fourth quarter last year. The CC spread is used to project forward current coupon yield, in addition to the stochastic swap-rates paths.3 This spread mildly tightened by 15 basis points (bps) year-on-year by June 2021, which helped to lower forward mortgage rates and slightly shorten duration.
Mildly Tighter Current-Coupon Spread Shortened MBS Duration Slightly
Source: MSCI MBS Current Coupon Model
- Primary/Secondary (P/S) Spread: The P/S spread is the differential between the prevailing mortgage rate borrowers pay and the CC yield implied in the secondary MBS TBA market. This spread moved above 160 bps, an historic high, last summer due to extremely high refinance volume that overwhelmed lenders’ origination capacity. As prepayment has slowed in the past three months, and in response to higher rates, the P/S spread has tightened to about 110 bps. This relief steered duration significantly shorter.
P/S-Spread Compression Alleviated Yield-Curve Steepening, Shortening MBS Duration
Sources: Freddie Mac, MSCI Primary-Secondary Mortgage Spread Model
- Price Premium: MBS duration is also a function of the quoted price premium, as the loss of premium due to prepayment varies at different prices. We sequentially adjusted the same underlying generic cohorts’ prices to match those of June 30, 2021. A slightly lower price premium led to mildly longer duration.4
- Burnout: The burnout here has three components: explicit burnout as loans with attributes for faster prepayment exit; implicit burnout as only less reactive borrowers remain as bond collateral; and the dissipation of the media effect as mortgage rates start to rise from historical lows. This factor led to significantly longer duration, although the primary mortgage rate was about the same, near the 3% level, for the two dates we are comparing.
- Coupon Drift: As record refinance activity in the last year helped borrowers lower their mortgage rates and monthly payments, the composition of the MBS universe evolved, leading to the 55-bp downward drift of weighted-average gross coupon (WAC).
Distribution of Loan Rates Drifted Lower, Extending MBS-Index Duration Significantly
Sources: Fannie Mae, Freddie Mac, Recursion
The following exhibit summarizes the sequential effects of each of the six competing factors. Curve steepening, burnout and coupon drift pushed the MBS index duration longer, while the effect of “sticky” mortgage rates that move down more slowly than they move up (more on various spreads’ compression) alleviated some of the extension. Cumulatively, though, the 30-year-MBS index’s duration extended drastically, from 1.1 a year ago to 3.7 currently.
Factor-Based Duration Analysis Revealed Six Main Factors for MBS-Index Duration Change
The effect for each factor was sequentially attributed. Sources: Fannie Mae, Freddie Mac, MSCI Agency Prepayment Model Version 2.0, MSCI Two-Factor Interest Rate Model
In summary, investors may want to adopt factor-based duration analysis for MBS indexes, tracking and attributing duration changes to components. This can give insight into both the dynamics of the MBS market and the characteristics of MBS models.
1Several other factors, such as volatility surface, did not exhibit significant effects for the period under discussion.
2Yu, Yihai, and Zhang, David. 2019. “MSCI Current Coupon Models: Model Risk Premium in a Risk-Neutral Model.” MSCI Model Insight
Zhang, David, Yu, Yihai, Voros, Miklos, and Biro, Istvan. 2020. “Agency MBS Current Coupon Calculation from TBA Prices.” MSCI Model Insight
3Yu, Yihai, and Zhang, David. 2020. “A ‘Normal’ Choice of Interest-Rate Model for MBS.”
4To assess this marginal effect, we held the generic cohorts constant as of June 30, 2020, excluding mortgages issued afterward.