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Low loan balance 15-year pools have excellent convexity
admin | October 26, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Investors in 15-year fixed rate MBS can add call and extension protection with pools backed by lower loan balances. Borrowers with smaller loans typically show faster housing turnover and, when interest rates drop, refinance more slowly. The price premiums for the paper are relatively inexpensive, especially for 3.5% pools trading close to par. And with the latest bout of rate volatility, a little convexity might help.
Low loan balance pools have very flat S-Curves
Borrowers with smaller loans have less incentive to refinance than those with larger loans, since less money is saved on a refinance. This makes it more difficult to cover fixed origination costs such as the appraisal and credit report. However borrowers with smaller loans tend to move more frequently, which boosts discount prepayment speeds. Borrowers with lower balances backing 15-year MBS behave in this fashion, resulting in flat S-Curves that offers both call and extension protection (Exhibit 1).
Exhibit 1: Low loan balance 15-year pools have very flat S-curves
Source: Fannie Mae, Freddie Mac, eMBS, 1010data, Amherst Pierpont Securities
The exhibit shows S-Curves for the 2014 to 2017 vintages, pulled from Fannie Mae and Freddie Mac’s loan level datasets. S-Curves are shown for four low loan size categories and for “generic” loans with balances greater than $200k (excluding jumbo conforming loans). The generic loans’ S-Curves peak at roughly 15 to 20 CPR for all but the newer 2017 vintage, while the various low loan balance groups peak 5 to 10 CPR lower.
Low balance loans prepay faster than the generic loans when out-of-the-money, with speeds generally increasing as loan size decreases. For example, in the 2016 vintage the generic loans slow to roughly 5 CPR when they are 50 bp out-of-the-money, while MLB loans prepay at roughly 10 CPR and LLB loans 1 to 2 CPR faster than that. The MLB S-Curve is virtually flat, and the LLB S-Curve looks slightly inverted.
Pay-ups are low and extension protection seems especially undervalued
Exhibit 2 (below) shows theoretical pay-ups for 15-year low loan balance collateral using Yield Book’s new model (version 21.4). Theoretical pay-ups are calculated by running representative new issue low loan balance pools at the same OAS as the corresponding new issue generic pool and compared to current market pay-ups.
Exhibit 2: Payups are very low on 3.5% low loan balance pools (as of 10/24/2018)
Source: Yield Book, Amherst Pierpont Securities
Market pay-ups on 3.5% coupon pools are currently very low, ranging from roughly 6% to 16% of theoretical value. Pay-ups are higher on 4.0% pools, although still significantly cheaper than theoretical; they range from 65% of theoretical value for LLB pools to 73% for $200k max pools. The benefit of the flat S-Curves are apparent in the convexities, which improve substantially as loan size decreases.
The fact that pay-ups on 3.5%s are significantly lower than the model calculates suggests that the market is undervaluing the extension protection on this collateral.
Of course, it is important to note that yields and nominal spreads on pools backed by larger loans typically run higher. The greater negative convexity of the larger loans does come with some compensation. But with the latest bout of interest rate volatility, a little convexity might look better.
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