By the Numbers
Relative value in prime 2.0 points to investor pass-throughs
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. This material does not constitute research.
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
Source: Amherst Pierpont
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
Source: Amherst Pierpont
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.
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 © 2024 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.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
