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.
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