5 Tips for Navigating Market Uncertainty

During this time of rapid and drastic market changes, we believe that it is important for long-term investors like financial institutions to be patient and remain calm. Liquidity was very poor last week and realized volatility for US Treasuries and Mortgage Backed Securities (MBS) has been historically high. In general, now is NOT the time to sell quality assets. However, this is the time for financial institutions to remain diligent and make sensible and timely decisions.

As global policymakers continue to provide support to aid market functionality, COVID-19 is affecting the mortgage market dramatically with lockdowns delaying loan closings and potentially impacting MBS supply and prepayments. Discussions of mortgage payment delays are also sparking concerns for real estate investment trusts and other participants, while large loan originator refinance rates have spiked to close to 5% for 30-year loans.

While no one knows exactly how long the global health crisis and market volatility may last, here are a few specific tips to help navigate market uncertainty.

1. Stay calm.

Be reactive, but not overly reactive. Financial institutions may want to move quickly to lower deposit rates in keeping pace with decreased funding costs in the broader market. They should also keep a cool head on the asset side of the balance sheet. Hold on to those higher credit-quality assets. We believe that liquidity on the balance sheet is likely to surge in the coming months.

2. Keep pricing models tuned and timely.

Volatile markets can make loan and prepayment models stale in a matter of hours (not days or weeks). We suggest allowing extra cushion in loan rates. Unless your model uses real-time interest rate updates, it could be behind the curve in terms of market proxy. The same goes for liability pricing. Consumer rate-sensitivity typically drops substantially as “flight to quality” mentality ensues. Dropping interest/dividend rates on deposits will probably not drive away deposits as much as expected. Investors will likely pull funds out of riskier assets and reduce spending, resulting in increased deposit balances.

3. Look for opportunities to add wider spreading assets.

Sticker shock on higher priced bonds may cause bond investors to balk at comparatively lower yields. Staying focused on risk-adjusted spreads may help to identify the better investment opportunities. Increased volatility tends to cause a widening of spreads. This presents an opportunity to capture high credit quality assets before calmer markets return and spreads compress back to normal levels. When spreads are wider, hedged return expectations are also higher. Return on Equity and profitability levels are heightened. Investors are well compensated for increased market volatility and increased cash flow uncertainty when spreads expand.

4. Manage your interest rate risk with derivative and other funding/hedging strategies.

Long term funded mortgages look attractive and it is extremely cheap to hedge interest rate risk with derivatives right now making hedged spreads very attractive. Institutions who aren’t prepared to take advantage of this in today’s market should start planning now. It takes time to get derivatives policies and procedures in place. Those who start preparing now will be ready to act when the market presents the right opportunity again. In the meantime, there is the option to lock in low cost, longer term borrowings from the Federal Home Loan Bank and similar funding sources.

5. Communicate with staff, borrowers and depositors.

During times of uncertainty, constant communication is important. There may be questions as to why deposit rates are falling so much, or why mortgage rates are lagging. Chaotic markets generally have short lifespans. Confidence during turbulent times will help alleviate anxiety until stability returns.

With increased volatility comes greater potential opportunities. Don’t look at today’s markets like the sky is falling. Instead, seek out quality prospects. All spreads are widening. Reset expectations for future returns. With more uncertainty comes a higher return requirement. Expect the biggest changes in areas where the cash flows are most uncertain.

Darren Fago, CFA is the Director of Advisory Services for financial advisory services firm ALM First headquartered in Dallas, Texas.

Robert Perry is a Principal for financial advisory services firm ALM First headquartered in Dallas, Texas.