By the Numbers
Relative value in prime 2.0 points to investor pass-throughs
Chris Helwig | December 3, 2021
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 recent widening and convergence of spreads across the capital structure in prime 2.0 MBS has created some clear and substantial relative value. While option-adjusted spreads have widened across most of the capital structure, the widening has not come equally, and some cash flows appear distinctly more attractive. That seems especially true of 3.0% pass-throughs backed by agency-eligible investor loans. The convergence in nominal spreads between jumbo and investor pass-throughs suggests that growing negative convexity in the jumbos may not be adequately priced by the market, giving better relative value to investor collateral across the coupon stack.
Gauging relative value in prime pass-throughs
Recent widening in nominal spreads has translated to wider option-adjusted spreads across most prime pass-throughs. Cohorts of prime pass-throughs issued this year saw OAS reach their near-term tights in early November and have steadily widened throughout the month. Higher-coupon current-vintage pass-throughs backed by investor loans have seen the most significant widening with spreads out roughly 20 bp over the course of the month. Widening in higher coupon private label pass-throughs has been driven to some extent by the overall widening in underlying benchmark option-adjusted spreads as spreads on FNCL 3.0%s have widened by roughly 10 bp over the same period (Exhibit 1).
Exhibit 1: OAS have widened across most prime pass-throughs
Spreads in 2.5% pass-throughs have widened by roughly 15 bp since the beginning of November across both prime jumbo and investor collateral. The move wider in 2.5%s appears to be consistent with higher coupon pass-throughs as they have widened by roughly 10 bp more than widening observed in the underlying benchmark. Despite a convergence in nominal spreads between the two stories at just over two points back of their UMBS benchmarks with investor pass-throughs widening out near prime jumbo levels, there is little difference in the relationship of OAS on the two cohorts as investor pass-throughs have steadily offered roughly 15 bp of additional OAS over prime jumbo.
Within the respective cohorts there is some reasonable tiering with regards to OAS across deals with different loan attributes. Across the universe of 3.0% investor pass-throughs, OAS ranges from 66 bp to 80 bp. Higher option-adjusted spreads were generally consistent with lower average loan sizes while gross WAC had less of an impact on OAS. The more muted impact of gross WAC on OAS in investor collateral is likely a function of relative levels of moneyness across coupons in investor loans given the wide range of incremental LTV-based SATO on investor loans. Due to this, gross WAC relative to PMMS does not equate to the same amount of moneyness across different investor deals.
OAS across the 2.5% coupon ranges fairly materially. Investor pass-throughs generally offer wider OAS than prime jumbo although there is convergence in OAS in investor bonds that trade to tighter OAS and prime jumbo bonds that offer wider spreads (Exhibit 2).
Exhibit 2: Sizing up OAS across 2.5% prime pass-throughs
Similar to 3.0% pass-throughs, loan size appears to be the predominant driver of OAS in the 2.5% cohort and the convergence in OAS between investor and jumbo bonds is broadly consistent with the convergence between higher ALS investor deals and lower ALS jumbo. Investor 2.5% with the widest OAS had average loan sizes of less than 300,000 and gross coupons of less than 3.25%. The widest OAS in prime jumbo space was in lower WAC, lower ALS Provident prime jumbo deals whose average loan sizes were less than 500,000 with WACs less than 2.75%. Conversely, prime pass-throughs that exhibited some of the tightest OAS spreads had average balances well above $1,000,000 with WACs in excess of 3.0%.
The recent convergence in spreads between prime jumbo and investor 2.5% pass-throughs is somewhat surprising as it has been driven by relative underperformance in investor spreads. The private label market is bracing for increased competition from the GSEs next year in the face of recently announced jumbo conforming limits that now exceed $970,000 in high-cost areas. The nearly 20% jump in jumbo conforming limits should increasing negative convexity in jumbo deals backed by loans that are now able to be more easily refinanced through agency channels. This increased negative convexity likely should have caused spreads between lower ALS investor deals and higher balance jumbo deals to decouple but instead they have done the opposite with both investor and jumbo pass-throughs trading between two and two and a half points back of UMBS 2.5%.
Most private label pass-throughs, particularly those backed by lower coupons, may be susceptible to underperforming next year simply as a result of the Federal Reserve beginning to taper purchases of MBS as less Fed buying may drive a widening in underlying benchmark spreads. Potentially mispriced negative convexity in jumbo pass-throughs could drive further underperformance. Conversely, the smaller role of the Fed in higher coupons could drive them to outperform relative to lower ones into next year. The combination of better relative benchmark performance and the muted impact of higher loan limits in lower ALS investor collateral suggests that 3.0% pass-throughs backed by investor loans may be poised to outperform other cohorts into next year.