Another Reason Mortgage Rates will Fall

As rate vol dips and the yield curve steepens, prepayment risk will abate

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Yesterday was a great day. I won my tennis match, and even better—sent my opponent into an angry tailspin. He ended up smacking balls against the fence repeatedly in frustration. Few things bring me greater joy.

To cap it off, I entered a lottery for the privilege of paying hundreds of dollars to see Taylor Swift play a year from now in Vancouver—and won (I’m a fan, and certain members of my entourage are full-blown Swifties). The price of similar tickets on Stubhub tells me I got very lucky. Great day.

You know who pretty much never has a great day? Mortgage bond investors.?

Consider this: when interest rates rise, inflicting losses on bondholders of all kinds, mortgage investors suffer more. That’s because the “duration” of mortgage bonds—the measure of the sensitivity of a bond’s price to changes in interest rates—shoots up right when rates start moving in the wrong direction.

And when interest rates fall—a good day for most bondholders—it’s only bittersweet for mortgage investors. That’s because lower interest rates raise the likelihood of mortgage prepayments, and the duration of mortgage bonds—their responsiveness to the boon of lower rates—drops.

Here’s how Michael Lewis, in his book, Liar’s Poker, described this “heads I win, tails you lose” situation:

“Whoever bought the bonds [...] couldn’t be certain how long the loan lasted. If an entire neighborhood moved (paying off its mortgages), the bondholder, who had thought he owned a thirty-year mortgage bond, found himself sitting on a pile of cash instead. More likely, interest rates fell, and the entire neighborhood refinanced its thirty-year fixed rate mortgages at the lower rates. [...] In other words, money invested in mortgage bonds is normally returned at the worst possible time for the lender”

Of course, financial markets are efficient, and the flip-side of every risk is a reward. Mortgage investors are rewarded with an interest rate spread over US treasuries for taking on prepayment risk. In fact, rising prepayment risk—and higher mortgage spreads to compensate mortgage bondholders for shouldering it—is one important explanation for how we got to near-8% mortgage rates.

They’ve declined over the past two weeks, but mortgage rates are still more than 5% higher than this time three years ago. It’s hard to imagine the housing market returning to a semblance of normality—with homes frequently trading hands, a healthy stock of inventory, and affordability off multi-decade lows—unless mortgage rates subside further.

Happily, I think that’s exactly what we’re in for.?

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One reason I think mortgage rates will fall—and the subject of today’s article—is that prepayment risk is set to decline, and along with it the compensation in the form of extra spread that mortgage bondholders have until now demanded.

Most forecasters argue this spread will stay as thick as it is today. I disagree—I think it will compress, adding to the tailwinds from declining US Treasury yields that I described in parts one and two of this series—and help propel mortgage rates towards 6% by the end of 2024.

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