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A convexity buy for FNCI
admin | August 9, 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.
Agency MBS investors can currently pick up the relatively better convexity of 15-year pass-throughs at some of the lowest spread concessions to 30-year pass-throughs in years. The option market is pricing for some of the highest interest rate volatility in years, and convexity should be valuable.
The option-adjusted spread or OAS between conventional 30- and 15-year MBS within the last week has approached the narrowed levels of the last five years. The difference has averaged 17 bp since 2014, but with the OAS of 30-year Fannie Mae MBS at 18 bp and the OAS of 15-year MBS at 17 bp, the difference now is only 1 bp (Exhibit 1).
Exhibit 1: OAS of conventional 30- and 15-year MBS has nearly converged
Source: Amherst Pierpont Securities
Nominal yield spreads between conventional 30- and 15-year MBS also are near the narrowest levels of the last five years. The difference in par coupon 30- and 15-year yields has averaged 62 bp since 2014, but with the par 30-year coupon at 2.53% and the par 15-year coupon at 2.13%, the spread is only 40 bp (Exhibit 2).
Exhibit 2: Nominal spreads between conventional 30- and 15-year MBS also have tightened
Source: Amherst Pierpont Securities
The narrowing spreads give investors a chance to pick up the generally better convexity of 15-year pass-throughs at the smallest OAS and yield concessions in years. Prepayments on 15-year pass-throughs generally lagged speeds in 30-year pass-throughs during the refinancing episode after rates dropped in summer 2016 and the more muted episode when rates dropped again in summer 2017 (Exhibit 3). Speeds on 15-year MBS then slightly exceeded 30-year as rates rose into mid-2018, leaving most of the MBS market trading at a discount.
Exhibit 3: Speeds have been more stable in conventional 15- than in 30-year MBS
Source: eMBS, Amherst Pierpont Securities
Other considerations are also worth weighing in any allocation out of 30- and into 15-year agency MBS::
- Yield curve: 15-year pass-throughs have more exposure to the front end of the curve, so steepening would favor the sector while flattening would help 30-year performance. As the Fed shows its likely hand, the curve should steepen.
- Spread duration: 15-year paper has shorter spread duration than 30-year,and shorter spread duration should be valuable in volatile markets
- Supply: outstanding 15-year supply has dropped steadily since late 2016 with outstanding 30-year supply on the rise, so the long-term trends lean toward scarcity in 15-year MBS. However, supply of 15-year pass-throughs tends to rise in refinancing waves, and that could keep spreads soft through the fall.
Assuming past prepayment patterns hold, and considering other factors, the relative convexity of 15-year paper should be valuable in the months ahead. The expected volatility of interest rates, at least as implied by the MOVE index, has returned to the highest levels since late 2016, presumably reflecting the risks of trade policy and the Fed’s response, as well as risks from a hard Brexit. Convexity should perform well.
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