The incentive for homeowners to refinance is long gone — that’s good news for GNMA bonds

• Prepayment risk from refinancing has virtually disappeared from the GNMA bond market.
• Because of this dynamic, the risk profile of GNMAs is more in line with Treasuries — yet they still deliver higher yields.
• Gaining exposure to the diversification benefits and AAA credit quality of GNMA bonds is even more compelling in the current market environment.

Above all else, bond investors value certainty. Lenders are willing to earn less from interest payments when they expect to fully recoup their principal investment.

From this perspective, US Treasuries are considered the ultimate “risk-free” investment. Nothing in this world is guaranteed, but if you lend the US government money, Uncle Sam will pay you back short of a zombie apocalypse. Like Treasuries, GNMA bonds are backed by the “full faith and credit” of the United States government. With GNMA bonds, if an individual mortgage borrower can’t pay their loan, the government steps in to pay back the bondholder.

Why, then, do GNMA bonds typically yield more than Treasuries? In the fixed income market, everything is relative. When payments come in early (i.e., prepayments), it introduces risk because we have to reinvest that money at prevailing market rates. This is referred to as prepayment risk. (Exhibit 1).

Mortgages can be refinanced, and prepayments from refinancing tend to speed up when mortgage rates are low. When this happens those cash flows then have to be reinvested at lower rates. Similarly, prepayments tend to slow down when mortgage rates are high, exactly the time when investors would benefit from reinvesting at current (higher) rates. This environment is bad for GNMA bonds and part of the reason why the GNMA index was down ~10% in 2022.

However, looking forward, GNMA investors are in a sweet spot. Most homeowners are deeply disincentivized to refinance because mortgage rates were at historic lows in recent years. Therefore, if rates rise further, the impact on prepayment speeds will be minimal. At the same time, rates would have to fall substantially for the incentive to refi to return for most borrowers. Taken together, this means that a large source of prepayment risk (changes in interest rates*) has been removed.

For the past 20+ years, prepayment risk in the GNMA market has varied in magnitude. But in today’s environment, it is very low.

Bond investors use a metric called the conditional prepayment rate (CPR) to estimate prepayment speeds. A higher CPR means faster prepayments.

For GNMA bonds, the CPR is significantly influenced by mortgage rates. The last time mortgage rates were this high was in 2002. At that time, CPR was 25, which is relatively high by historical standards (Exhibit 2). Why is this environment of elevated mortgage rates different?

In 2002, borrowers, on average, were paying about 7.5% on their mortgages, but the prevailing market rate of 7.2% was lower, providing an incentive to refinance. Today, the average borrower is paying 3.6% on their mortgage, and the prevailing market rate is more than 3% above this average rate. As the dark gray line in Exhibit 2 shows, this is a historically wide gap.

The incentive to refinance is long gone, meaning prepayment risk is also very low. But prepayments are influenced by other factors unrelated to mortgage rates, such as migration, death and foreclosure. These events also cause a mortgage to be prepaid, and they therefore introduce prepayment risk. The good news here is that these other factors are unrelated to the level of interest rates, and therefore prepayments of this form are just as likely in a high-rate environment (good for investors) as they are in a low-rate environment (bad).

• Today, prepayment speeds have slowed significantly in the higher-rate environment.
• Going forward, however, prepayment speeds will be significantly less impacted by changes in interest rates, and a large source of risk for GNMA bonds (prepayment risk) has therefore diminished.
• This means that GNMAs are now more comparable to Treasuries from a risk perspective, yet they continue to command higher yields.

Against a backdrop of higher yields versus Treasuries and very little prepayment risk, we believe the opportunity to invest in GNMA bonds has never been more compelling.

^{* The relationship between prepayment speeds and changes in interest rates is referred to as “negative convexity”.}