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Sell 30-year 2.0% pass-throughs, buy 15-year 2.0%

| September 25, 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.

Par 30-year MBS continues to tighten to 15-year MBS, opening the door to trading out of 30-year 2.0% pass-throughs and into 15-year 2.0% pass-throughs with a net gain in carry and convexity.

On the tight end of the spread range

Nominal 30-year spreads now trail 15-year by only 22 bp while, in OAS, par 30-year MBS trades 13 bp tighter (Exhibit 1). For context, the nominal 30-to-15-year gap has traded wider than 22 bp in more than 85% of sessions in the last five years with the OAS gap running wider in 95% of sessions. The gap between the sectors is on the tight end of the 5-year range.

Exhibit 1

Source: Bloomberg as of 9/22/20, Amherst Pierpont Securities

Better convexity in 15-year MBS

Tight OAS with wide nominal spreads partly reflects greater negative convexity in 30-year MBS. The longer paper tends to show more cash flow volatility (Exhibit 2). Primary mortgage rates on 15-year loans often come in below the rates on 30-year, helping lift speeds on 15-year MBS in markets with limited refinancing. But 15-year pass-throughs historically trail 30-year paper in refinancing, even with similar refinancing incentives. The greater negative convexity in 30-year paper contributes to greater option cost.

Exhibit 2: More cash flow volatility in 30- than in 15-year MBS

Source: eMBS, Amherst Pierpont Securities

More option cost in 30-year MBS

Tight OAS with wide nominal spread also partly reflects a steep vol curve—a market that expects more yield volatility in longer than shorter rates, and 30-year MBS is more sensitive to those more volatile longer rates. For example, 5-year rates currently have implied yield volatility of 41.4 bp over the next year while 10-year rates have 61.4 bp (Exhibit 3). In other words, 30-year MBS has higher option cost.

Exhibit 3: A steep vol curve means more option cost for 30- than 15-year MBS

Note: Data show annual volatility in basis points implied by 1-year options on 1-year forward swap rates as of 9/22/20.
Source: Bloomberg, Amherst Pierpont Securities

Finding a way to position 15-year MBS with net positive carry

Special dollar rolls in 30- and 15-year MBS complicate the job of reallocating into 15-year MBS. The dollar roll is special in 30-year 1.5% through 3.0% coupons and in 15-year 1.5% and 2.0% coupons.

One place to consider reallocating is out of 30-year 2.0% pools and into 15-year 2.0%. The longer duration of the 30-year paper would allow an investor to add substantially more par exposure in the same 15-year coupon (Exhibit 4). For example, the TBA 30-year 2.0% dollar duration of 4.81 is 180% of the TBA 15-year dollar duration of 2.67. An investor could sell $100 million of the 30-year paper and buy $180 million of the 15-year paper and have the same dollar duration. And with the dollar rolls in each coupon, the larger 15-year position would have better absolute carry. That gives an investor a duration-neutral position in 15-year MBS with better carry and better convexity.

Exhibit 4: Comparing 30- and 15-year MBS risk and carry

Note: All market levels as of Sep 23 market open.
Source: Amherst Pierpont Securities

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