Mining for relative value in prime pass-throughs
admin | February 21, 2020
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 nearly $20 billion of issuance through the first six weeks of the year, investors in private MBS have had had more size and flavors of issuance to choose from than nearly any time in the post-post crisis era. Convexity seems mispriced in parts of both new issue and secondary markets. New pass-throughs backed by agency-eligible investor loans appear mispriced given the pay-ups those pools fetch in the agency specified pool market. In secondary space, seasoned pass-throughs backed by lower WAC pools appear mispriced as well.
Looking at the world in nominal terms
Spreads on 3.5% prime jumbo pass-throughs have tightened by nearly a point since the beginning of last year in spite of rising prepayments and a spate of prepayment interest shortfalls hitting certain prime jumbo super senior bonds. In spite of this, spreads on 3.5% prime jumbo pass-throughs have outstripped spread tightening on agency 3.5% pools. Despite the liquidity and financing advantage afforded by agency specified pools, jumbo pass-throughs are currently trading roughly on top of them in terms of their respective concession to the TBA benchmark. (Exhibit 1)
Exhibit 1: Jumbo 3.5% pass-throughs are trading in-line with their spec pool counterparts
Source: Bloomberg, LCD Research, Amherst Pierpont Securities
Given apparently stretched valuations in prime jumbo pass-throughs, investors may fare better in other prime collateral stories. Non-owner occupied collateral may offer investors some protection from elevated prepayments and better carry. Looking across the spate of recent prime jumbo issuance there has been some, albeit limited, price variance across different stories. At the tight end of the range, super senior 3.0% pass-throughs backed by agency-eligible investor loans and primarily owner occupied loans eligible for TBA pools have both priced at 20/32 back of UMBS 3.0%s. Given the recent rally and subsequent run up in pay-ups on investor 3.0% specified pools, investor pass-throughs seem mispriced. Investor 3.0% specified pools are currently trading at roughly 20/32s over the TBA benchmark. Given the fact that the loans pooled in the PLS are substantially similar to those that comprise the specified pool, the true ‘benchmark’ should be the specified pool rather than the TBA price. Given this, it appears that the investor pass-through priced as much as $1-08 back of its representative benchmark, putting it at one of the widest spreads back of an agency cohort in pass-through space.
In secondary space, 4.0% pass-throughs trade at by far the widest nominal spread at roughly 2.5 points behind UMBS 4.0%. With new issue spreads on 3.5% at roughly 24/32 back of their TBA benchmark, this would imply roughly a 12/32 negative coupon swap effectively pricing the 50 bp of IO at a concession rather than a premium and making the swap roughly 1.75 points cheap to the UMBS 3.5%/4.0% swap. From a practical perspective, there appears to be little ability to extract any value associated with this potential mispricing absent structural arbitrage. Given elevated prepayments and premiums, 4.0% pass-throughs appear to be capped at roughly a two point premium over par and any ability to extract value would likely be a result of stripping the pass-through down to a 3.5% coupon and selling the 50 bp IO strip at some, likely small, multiple of the coupon.
Looking at the world in OAS terms
On an option-adjusted basis, 4.0% pass-throughs offer the best risk-adjusted return but monetizing that value may be difficult given the prepayment and premium risk associated with those bonds. Away from higher coupon pass-throughs, seasoned pass-throughs backed by lower WAC pools appear to offer the best risk-adjusted return. Low gross WAC 2018 vintage 3.5% pass-throughs are currently trading at roughly 16/32 behind UMBS 3.5%, roughly on top of the spread at which conforming jumbo specified pools with comparable WACs and seasoning trade in the specified pool market trade. While these bonds appear tight relative to agencies, they should offer significantly better convexity than new issue 3.5% with higher WACs that trade at a mere 8/32 concession to seasoned lower WAC paper (Exhibit 2).
Exhibit 2: Lower WAC seasoned pass-throughs may offer attractive relative value
Source: 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.