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
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