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CMO barbells may lift returns over TBA pass-throughs

| June 28, 2019

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.

MBS investors can take advantage of today’s inverted yield curve to potentially outperfom TBA pass-throughs and add return to portfolios benchmarked against a broad mortgage index. The steep inversion at the front end followed by increasing rates at longer maturities has created a dip in the curve. This shape adds yield to barbelled portfolios consisting of a short and long bond. These portfolios can have better yield, OAS, convexity, and projected total return profiles than a TBA pass-through with the same duration.

Total returns on a barbell can exceed TBA

A CMO barbell has clear advantages in projected 1-year return over a pass-through with the same duration and market value (Exhibit 1). The barbell’s total return outperforms the pass-through’s in every scenario, and performance improves with larger rate moves in either direction. This reflects the better convexity of the barbell. As realized and implied volatility has moved higher in May and June, convexity has become more valuable.

Exhibit 1: A CMO barbell shows more convex returns than TBA pass-throughs

Note: Projected 1-year total returns on a combination of 64% FNR 19-36 EK (PAC) and 36% FNR 19-36 NF (Floater) net of returns on a proceeds- and duration-neutral position in TBA FNCI 2.5% pass-through. Details in Exhibits 3 and 4. Returns assume instantaneous parallel shift in the yield curve at settlement, reinvestment at 1-month LIBOR and horizon repricing as constant OAS. All market levels as of 6/27/19. Source: Yield Book, Amherst Pierpont Securities

The barbell consists of a longer CMO and a shorter CMO with a combined duration that matches a given TBA. A bond barbell is naturally more convex than the equivalent intermediate bond. While mortgages aren’t bullet cash flows, blending a longer and shorter bond to match an intermediate duration still improves convexity.

The yield curve has a sharp dip

The current yield curve has an interesting inversion at the short end (Exhibit 2). The inversion improves the execution of this strategy. The short bond tends to yield closer to the long bond in this environment, while with a typical curve would yield far less. The TBA’s duration is in-between the durations of the bonds in the barbell, so it tends to be most exposed to the dip in the curve. This lowers TBA yields relative to the bonds in the barbell.

Exhibit 2: The current yield curve is sharply inverted at the front end

 

As of 6/26/2019 close. Source: Yield Book, Amherst Pierpont Securities

Constructing a barbell

One example of a barbell might include a longer-duration PAC and a short-duration CMO floater, although other approaches could work, too (Exhibit 3). In this example, the longer bond is a 4-year, 3%-coupon PAC and the short bond is a strip floater with a coupon of 1-month LIBOR+45 bp with a 6.5% cap. Both bonds are backed by 30-year Fannie Mae 4.5% LLB and MLB Quicken pools. Although Quicken is typically a fast servicer, the loan balance collateral still provides prepayment protection. The PAC structure provides a second layer of prepayment protection to the long bond. The position is compared to a 2.5% 15-year TBA pass-through. This TBA has close to a 3-year duration, which is close to the lowest point on the inverted yield curve.

Exhibit 3: CMO barbell vs 15-year 2.5% TBA

Note: All market values as of 6/27/19. Market value reflects price and accrued interest. Source: Yield Book, Amherst Pierpont Securities

Any portfolio looking to sell TBA pass-throughs to buy a CMO barbell needs anticipate duration- and proceeds-neutral performance. The first step is to choose an appropriate proportion of the two CMOs such that the aggregate option-adjusted duration (OAD) matches the OAD of the TBA. In this example this means 64% of the par amount of the long position is allocated to the PAC and the remaining 36% to the floater. The second step is scale the combination to match the market value of the TBA.. Note the CMO barbell offers 41 bp higher yield, nearly 30 bp higher OAS and significantly better convexity than the TBA.

The barbell looks better than TBA for a total return investor

When it comes to projected total return, the barbell slightly outperforms the TBA in the base case, but as rates move in either direction the better convexity quickly improves the performance of the trade (Exhibit 4). The barbell outperforms the TBA by 80 bp in a 100 bp sell-off and by 87 bp in a 100 bp rally.

Exhibit 4: CMO barbell vs 15-year 2.5% TBA, total return profile

Note: Returns assume instantaneous parallel shift in the yield curve at settlement, reinvestment at 1-month LIBOR and horizon repricing as constant OAS. All market levels as of 6/27/19.Source: Yield Book, Amherst Pierpont Securities

Of course, it is important to note that the components of the CMO barbell trade with less liquidity than the TBA pass-through, and trading out of TBA also means the investor could miss any special TBA dollar roll financing while the trade is in place. This could change the performance of the barbell relative to the pass-through.

Nominal spreads on intermediate PACs off 30-year pass-throughs have slightly widened since early May while nominal spreads on 15-year pass-throughs have remained essentially flat, offering a reasonable entry point for building a barbell of this type.

In general, the yield curve has created a good opportunity for barbelled positions, and the CMO market offers a number of ways to put those positions on.

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