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Mining for relative value in prime pass-throughs

| 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

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