Grander 4th Quarter Commentary and Outlook

 2023 Year End Commentary and 2024 Outlook

Published February 2024

The last few months of 2023 saw a rapid reversal of the prior six months, which had seen long term rates move rapidly higher along with a noticeable increase in volatility costs. The 10-year dropped from a high print of just over 5.0% to a year end level of just below 4% – a significant drop, matched by an easing of par origination rates on new mortgage of just over 100 bps, from 7.70% to 6.62% to close the year.

The parallel drop-in rates and in volatility helped nearly every fixed income market show good performance – in particular prepayment sensitive markets such as agency MBS and callable paper – but with Fed Funds over 5.25%, leveraged investors continued to struggle to beat cost of funds driven performance hurdles. Those higher rates also high commercial real estate investors hard: with vacancies continuing to trend higher post-Covid, and refinancing rates higher than any time since the early 2000s, huge swathes of office and retail space built over the past two decades are facing significant valuation events. While this story will play out largely in 2024 and 2025, fixed income markets have already reflected this in reduced CMBS liquidity and higher demand for non-commercial assets. Diverging performance in the credit market could also be seen, with lower quality high yield names seeing significant spread expansion as investors focused on investment grade, high cash flow credits.

While the first part of the year drove exceptional MSR performance due to increasing par origination rates, the last three months continued that performance as volatility costs embedded in MSR discount rates dropped. Volumes, however, were light, as sellers saw the trends and largely let the market reprice. Grander’s funds saw another quarter of solid performance, although year end marks were lower than expected as third-party models were unable to reflect active pricing in secondary markets, and low prices on current origination coupons outweighed the continued slow prepays seen in older vintages.

 2023 Year End Commentary and 2024 Outlook

The past year saw a continuation of the volatility we’ve seen in fixed income markets since the turbulent early days of the Covid epidemic, although in this case, the year-on-year volatility was largely a washout, at least on the longer end of the curve. The story was driven by a tense dynamic between the Fed – signaling it would keep tight monetary policy for as long as the economy was not solidly back to a 2% inflation rate – and markets, desperate for cheaper money to support more leverage, kept trying to convince itself that the economy would worsen, and the Fed’s hand would be forced.

In a nutshell: The Fed won. The economy remained strong, with real GDP running at 3%, unemployment remaining at post-crisis lows accompanied by real wage growth of almost 2%, and inflation remaining cloying above its 2% target.

If you looked just the year end prints on the 10 year, you’d think nothing had happened – but actually the long end traded in a 150 basis point range, as low as 3.40% in the spring and as high as 5.00% in the fall. Markets first leaned against the Fed speak and rallied, but increasing signs that inflation was not dropping fast enough or broadly enough caused rates to back up in the fall, before improving data allowed the curve to fall back to a 4% range by year end, where it remains today.

Corporate credit spreads were largely directional with term rates, although the brief banking crisis in the spring – capped by the failure of Silicon Valley Bank and First Republic – led to broad initial spread expansion which largely cleared out as the year went on. In contrast, however, real estate lending tightened up during the year, with significant fears continuing to haunt spreads and liquidity – especially in commercial markets – throughout the year.

Mortgages – which is Grander’s focus – saw varying performance, but residential markets closed the year showing signs of real life. The 30-year conforming rate rose steadily from 2022-year end into September, peaking with a Freddie survey rate top of 7.72% before falling back to 6.69% at year end, while non-QM markets saw origination rates soar from roughly 8% at the beginning of the year to well north of 10% for super jumbo and low doc loans before settling back to 8.5-9.0% rates at year end. Prepayments were predictably glacial, with 2021 and 2022 production seeing all-in CPR rates below 4%. With such massive incentives to stay put, borrowers also performed well, with delinquency and buyback rates also trending at post-crisis lows. New production was limited almost entirely to purchase originations, and with home construction and existing home sales still somewhat quiet, 2023 will go down as one of the smallest origination years since the collapse in 2008 and 2009.

The place to be in 2023 (at least in fixed income) really was MSRs: with low production, servicers slowly bid up MSR purchase multiples and tightened bid spreads for secondary product, while the same dynamics meant little flow product emerged – and at such high coupons that secondary buyers like Grander had little interest. With CPRs low, and with forward curves predicting a long and slow easing cycle not expected to begin until mid to late 2024, cash flow on existing pools was very good, certainly much better than models at origination would have suggested, and embedded value in escrow balances rose significantly through the year.

Looking forward, we expect continuing low CPR rates as the Fed focuses on getting “the last mile” out of the inflation battle. In addition, with the Fed, we share the view that long term normal rates will now be comfortably above the zero-rate environment that persisted post-crisis for more than a decade. That should support par origination coupons for conforming product in the 5.5%-7.0% range for the foreseeable future, keeping the 2.75-4.0% average coupons targeted for Grander’s MSR portfolios deep in the money. Moreover, those higher long term normal rates will necessarily flush out a lot of marginal borrowers in commercial real estate and corporate markets; we expect 2024 to be another good year for MSRs (although more of a normalized year compared to 2023’s stellar results), and a better year for residential MBS investors overall.

Grander’s portfolio performed well yet again. GMOF I closed in September, capping off quite possibly the best investment window (Q3 2021 to Q3 2023) that could have been hoped for. Performance since inception is almost 38%, or 17% annualized, during a period when the fixed income markets – and alternative fixed income in particular – were down across the board. As always, we thank our investors for their ongoing support, and we have been pleased to show such strong performance for their investments with us.

3Q 2023 Fixed Income and Mortgage Market Commentary

Published October 2023

Watching CNBC one morning, I caught a ten-minute segment where Rick Santelli talked about rate moves on the back of the employment data, followed by the youthful talking heads talking about the shocking backup in the curve – 30 bps in under two weeks! – and the capped off with Jim Cramer giving an anecdote about comparing Coke and Pepsi stocks forty years ago as a junior analyst at Goldman. And it occurred to me that, depending on when you started your career, you end up having a set of experiences that govern what your intuitive brain will expect: 

  1. Rick Santelli: You started your career in the 80s, in which case volatility and “high rates” are fine, but subject to a normal range; or,
  2. CNBC Anchor: You started your career in the 90s, in which case rates generally fall whenever they go up a bit, but trend down over long horizons; or,
  3. Most MBS Traders: You started your career in the 00’s, in which case you think rates are broadly supposed to be at or near zero.

Unless you started your career in the Johnson administration, however, your go-to, ingrained-at-the-start sense of what the curve “should” do will not be “rates generally drift higher.” Well, welcome to the Johnson administration: inflation is trending higher as the government spends on guns (Ukraine, Taiwan, Israel) and butter (the Inflation Reduction Act); relative money supply is shrinking during a relentless low unemployment cycle; and we’re seeing the beginnings of a productivity wave that will have uncertain effects on employment and wage growth.

“Isn’t this an MSR commentary,” you may ask? Yes, of course it is – but remember the last time this financial and macroeconomy existed, there was no mortgage securitization market. Lou Rainieri, in 1967, was only just starting to wear wide brown ties with badly matched striped shirts. Bond traders didn’t do math – they looked up prices on rate sheets the same way they’d look up a number in a phone book (Google both). The MBS market as we know it, in other words, has never lived through a period like the last two years – but interest rates have. And since we don’t use rate sheets, we use

YieldBook and Bloomberg and Excel, we can model what should happen going forward.

First though, a little look back. Q2 2023 will be remembered as the beginning of the full-scale renormalization of the curve. The Fed’s activity in 2022 was aggressive, but the back end made everyone feel like “well, maybe this is just a fix it”. Powell and his fellow mouthpieces couldn’t say it loud enough – this will be higher, for longer, and that’s a good thing – so markets kept waiting for signs of a return to ZIRP. This quarter, though, was capitulation, the ugly early stage of capitulation where markets realize they got it wrong but are close to when they were wrong and therefore are still sort of embarrassed about how dim they look as many stories emerged about whether the world could survive higher rates as anything about how it would happen. The 10y is now ranging towards 5.0%, having drifted upwards from 4.3% in mid Q2, with effectively no real movement in the 2-year rate except to reflect the most recent two Fed moves.

 The bear steepener we’ve witnessed is probably not done yet, as inflation remains stubbornly above 3% and inflationary pressures remain high – low unemployment and high deficits being the temporary rule of the day.  The mortgage basis, though, also remains high – despite the fact that high headline rates are killing mortgage origination volumes and thus rapidly drying up profitability among originators. Servicing income – and MTM increases in legacy MSR values – are seemingly the only positives for the non-bank players, and even for many of the bank originators who are suffering from NIM compression and MTM losses, realized or unrealized, on securities portfolios.  

But if we imagine a future where the short end is anchored – as I was taught – in a long term normal Fed Funds rate equal to nominal GDP growth plus expected productivity growth, the long end was normally positively sloped at 10-15 bps per maturity year out to 15 years, and mortgage basis was set off the 10 year based on a long term average correlation with the vol pricing of 3×13 swaptions, we are actually getting pretty close to normal. The 10 year needs to back up another 150 bps to be truly normal, but what will likely happen is the 10 year will back up 50 bps and the 2 year will drop 100 bps over the next 18 months. That will give us Fed Funds expectations of around 3.75% – exactly what the Fed wants us to think – which is roughly nominal GDP plus a drifting higher productivity level. The 10 year will be in the 5.5% range, and vol should come down, creating a mortgage basis of not 300 bps, but more like 150 bps – and leaving the par 30 year rate around 7.0%. 

For the mortgage market, that will lead to a kind of trickling Goldilocks environment. Trickling, because unless home prices actually fall, affordability means there won’t be much new origination, and only the bravest of renovators will refi or cash out refi from even recent origination into a new loan. Volumes will lag, and originators will continue to staff down, sell out, or go out of business. MSR buyers, though – even at more recent WACs in the high 5-low 6% range – should see lower than normal CPR rates well into 2025, along with robust escrow income. Delinquencies and defaults should also remain as they have been, in a historically low range since the Covid forbearance scare. All in all, it’s still a good time to own and be layering into MSR positions, both base and excess, although value will continue to be concentrated into base pieces. 

As for MBS more broadly, we finally like current coupons again, after having been biased towards highly seasoned 3.5-4.0 coupon paper going back for over a year. Spending the time in this market to make bets in specified pools is always worth the efforts – especially given the size of the super pools during the last refi wave and the demographic changes that are sweeping across the borrowing market in the wake of the structural restructuring of the US domestic workplace economy. But today, buying into new origination 6.0-6.5% pools, with a focus on bank originators away from the West Coast (and in New York if you can find the paper), will be viewed smartly in the near future. 

In the non-QM space, those demographic changes also have us looking for New York, New Jersey, and California new purchase paper in the just-slightly higher than jumbo balance tiers with full documentation – basically, if you’re buying that home today, in those locales, you’re making a statement because it’s too easy to move to Austin or Tampa. Low doc or stated income paper will have more hair than usual, and we like non-judicial foreclosure states right now in particular, as political uncertainty often leads to backups in litigation and to trigger-happy legislatures changing priorities for judges on the bench. But coupons remain very attractive, and non-QM in general is still a critical focus for Grander looking forward. And by “attractive”, we mean high coupons for investors – non-QM borrowers will be exercising the same budgeting skills that Americans first honed back in the Carter administration. 

Closer to home, please join me in welcoming Dave Hass to the Grander team – he’s running our secondary markets efforts to acquire and manage our MSR portfolio from our favored sellers. Dave and I are both of the 90s “Gen X” cadres of MBS traders, but we also seem to share a love of history that makes us respect Paul Samuelson and all the bond traders who navigated Nixon’s drop kick of Bretton Woods. We’ll report on how year-end shaped up, and give a fuller insight into 2024, when we present Q4’s analysis in January.

1 Comment

  1. granderi on November 1, 2023 at 5:06 pm

    Excellent summary

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