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The case for reallocating from 30-year MBS to 15-year

| March 6, 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.

Spreads on 15-year pass-throughs routinely underperform 30-year pass-throughs as refinancing activity picks up and expected 15-year net supply rises, and the current market is showing the same. The lagging spreads come despite 15-year pools tendency to show lower prepayments and better convexity.  For banks and money managers, spread levels look good for reallocating from 30- to 15-year paper.

The typical OAS difference between par 30- and 15-year paper has moved toward its narrowest point in a year with 15-year pass-throughs recently trading only 5 bp tighter than 30-year (Exhibit 1). The difference was only smaller in the last year when it hit 4 bp on Sep 24. Fifteen-year paper on average in the last year has traded 13 bp tight to 30-year.

Exhibit 1: The typically shorter duration and better convexity of 15-year pools now trades only 5 bp inside 30-year

Note: data as of 3/5/20 COB. Source: Bloomberg, Amherst Pierpont Securities

The typical yield advantage in 30-year paper still holds, with par 30-year zero-volatility spreads around 10 bp wide to 15-year (Exhibit 2). However, the average zero-volatility advantage in the last year has been more than 26 bp. The market now requires a smaller yield concession to go from 30- to 15-year paper.

Exhibit 2: Nominal spreads between 30-year and 15-year pass-throughs also are narrow

Note: data as of 3/5/20 COB. Source: Amherst Pierpont Securities

Fifteen-year pools typically show more convexity than 30-year, and that has held recently. Since primary rates on 15-year mortgages typically run 40 bp to 50 bp below rates on 30-year, prepayment comparisons typically pit a given 30-year coupon to the 15-year coupon 50 bp lower. Prepayments on Fannie Mae’s 30-year 3.5%s of 2018, for example, have shown more negative convexity than 15-year 3.0%s of 2018 (Exhibit 3). The 15-year paper prepaid faster than 30-year when the two coupons traded below par in 2018 and slower when they traded at a premium afterwards.

Exhibit 3: Prepayments in 15-year pools typically show better convexity than 30-year pools with comparable rate incentives

Source: Amherst Pierpont Securities

Based on spreads between par 30- and 15-year paper last fall, 15-year paper could widen slightly more to 30-year. Spreads on par 15-year pass-throughs last fall moved to 8 bp wide to 30-year. But the most likely path would have 15-year paper tightening after refinancing activity peaks. After refinancing peaked last fall, par 15-year paper moved to 8 bp tight to 30-year, a 16 bp swing.

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