By the Numbers
Look to CMOs for short duration MBS
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.
The value of some CMOs relative to 15-year MBS is starting to look interesting. Fixed-rate 15-year MBS looked inexpensive against 30-year pools for much of 2021. But tightening in 15-year MBS has left the differences in nominal spreads and OAS between the sectors near the widest levels since the early days of the pandemic. Most of the net supply of 15-year pools is flowing into the Fed’s portfolio, and bank demand has jumped at the same time. Relatively inexpensive 30-year pools have become raw material for CMOs that look attractive relative to 15-year pools, picking up extra yield, OAS and convexity.
The curve-adjusted nominal spread for 15-year MBS is typically below the spread for 30-year MBS (Exhibit 1). The 15-year spread compares the 15-year current coupon yield to the 50/50 blend of the 3- and 5-year Treasury yields, and the 30-year spread references the 50/50 blend of the 5- and 10-year Treasury yields. The difference averaged 27 bp prior to 2020 and occasionally reached as wide as 40 bp. In early 2021 the spread tightened, turning negative from March through June. But the spread has widened since then and recently pushed above 30 bp.
Exhibit 1. Comparing nominal spreads of 30-year and 15-year MBS
Source: Yield Book, Amherst Pierpont Securities
Yield Book’s prepayment model shows a similar picture (Exhibit 2). The current coupon OAS spread averaged 13 bp prior to 2020 and has recently rebounded back to that level. The OAS spread was significantly tighter for much of the pandemic.
Exhibit 2. The 30-year to 15-year OAS spread is the widest since early 2020
Source: Yield Book, Amherst Pierpont Securities
Tight supply of 15-year MBS has been a major driver of richer valuations. Over the last few months, the Fed has bought almost all the net supply of 15-year pools. At the same time, bank portfolios stepped up buying of shorter MBS in preparation of Fed tapering.
Relatively wider spreads in 30-year MBS become raw material for a CMO with similar duration to a 15-year pool but with higher yield and OAS (Exhibit 3). This compares a 1.5% coupon PAC backed by seasoned 30-year collateral to a duration- and proceeds-neutral combination of the 15-year TBA and cash invested at IOER (15 bp). The CMO offers 11 bp more yield, 5 bp more OAS, and has less negative convexity than the 1.5% FNCI TBA.
Exhibit 3. A CMO can offer higher yield and OAS than 15-year MBS
Source: Yield Book, Amherst Pierpont Securities
The CMO offers better total returns when rates move (Exhibit 4). The table shows total returns over a 1-year horizon. The scenarios assume the yield curve shifts gradually over the next year. The CMO outperforms the 15-year TBA if rates fall more than 50 bp or increase more than 25 bp. But the TBA does better if rates stay roughly range bound.
Exhibit 4. Total returns of 15-year MBS and a similar duration CMO
Note: Using Yield Book’s v21.7 prepayment model. Source: Yield Book, Amherst Pierpont Securities
Investors that can dollar roll may still prefer the TBA since the roll is currently trading special, which can significantly boost returns. However, it is not certain that the roll will remain special when the Fed tapers. And the TBA investor faces the risk that 15-year spreads might widen when the Fed tapers and net supply increases. Investors should also be aware that the CMO’s PAC bands could drift if interest rates drop and prepayment speeds increase. The CMO is likely to trade wider if that happens. However, the total return scenarios assume a constant OAS and therefore likely overstate the value of the CMO in a rally.
Brian Landy, CFA
blandy@santander.us
1 (646) 776-7795
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.
Important Disclaimers
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.
