Going out-of-index to add convexity
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.
With price premiums to TBA on many specified pools trading between 40% and more than 100% of the mark implied by TBA option-adjusted spreads, investors should be shopping for other ways to add convexity and return to benchmarked agency MBS portfolios. One potential source is new ‘AAA’ pass-throughs backed by legacy private MBS loans.
Falling rates have given a lift to the potential value of highly seasoned, credit-impaired loans that have exhibited slow and generally stable prepayments even when readily refinanceable. The relative value associated with this collateral is not exclusive to the private MBS market. The convexity profile of these loans compares favorably to loan balance stories in the agency specified pool market. In fact, New Residential’s NRZT securitizations of loans sourced by calling legacy MBS deals exhibit a prepayment S-curve similar to seasoned Fannie Mae loans with low loan balances. Called loans that have had principal balance modifications have prepaid even slower than Fannie Mae low loan balance loans. This type of convexity and call protection can cost upwards of a $4-00 premium over TBA in certain Fannie Mae MBS but can be acquired relatively inexpensively through private MBS, admittedly with a substantial liquidity give (Exhibit 1).
Exhibit 1: Seasoned called loans exhibit similar S-curves to agency low loan balance
Source: Fannie Mae, eMBS, 1010data, Amherst Insight Labs, Amherst Pierpont Securities
The potential in private MBS is clear in projected total returns. The ‘AAA’ pass-through class of NRZT 2019-1 compares well to a blend of Fannie Mae TBA pass-throughs. The pass-through portfolio is comprised of roughly a third allocation of FNCL 2.5% and two thirds FNCL 3.0%. Admittedly, conventional 2.5%s are a small component of the index but may grow if they become the production coupon for a sustained period of time. The likely greater value associated with the trade is using the seasoned pass-through as a surrogate for conventional 3.0% pass-throughs, which are a much more significant contributor to index weightings. However, models have TBA 3.0% pass-throughs roughly a year shorter in effective duration than the NRZT pass-through creating the need to layer in the 2.5% coupon to bring the analysis dollar DV01 neutral.
Compensation for selling liquidity by shedding TBA exposure and adding the seasoned pass-through may be significant. The NRZT bond has an incremental 60 bp of model yield and an additional 106 bp of OAS above the blended pass-through portfolio. The NRZT bond is roughly a year shorter on the curve than the blended pass-through portfolio, potentially offering better key rate duration into a front end bull steepening. It is also more positively convex than the pass-through depite being more structurally levered through the private MBS bond’s shifting interest structure. (Exhibit 2)
Exhibit 2: NRZT pass throughs offer better projected yield, convexity and curve exposure
Source: YieldBook, Amherst Pierpont Securities
Given its better projected yield and convexity, the NRZT bond offers better projected total return across a range of yield curve scenarios. Given its better projected yield and carry, the NRZT pass-through offers an incremental 47 bp of base case total return. And given its significantly better convexity, the bond offers anywhere from 55 bp to 287 bp of incremental return over the pass-through blend into a rally or sell off. (Exhibit 3)
Exhibit 3: NRZT pass throughs offer better projected annual total return
Source: YieldBook, Amherst Pierpont Securities
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.