By the Numbers

Wide spreads give MBS a lead in the total return race

Brian Landy, CFA | September 30, 2022

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.

Investors paying attention to agency MBS probably know all about the unusually wide nominal and option-adjusted spreads in the market, but potential total returns may be less clear. Current spreads and the income they generate give MBS a sizable head start in the total return race. And projected returns in conventional 30-year pass-throughs with coupons from 2.0% through 5.5%–especially in higher coupons—consequently beat returns in Treasury debt by significant amounts over a wide range of interest rates. Conventional 15-year pass-throughs track 30-year MBS returns in lower coupons but fall behind at higher coupons. Moving up-in-coupon using 30-year pass-throughs should outperform 15-year MBS and low coupon 30-year MBS.

Strong projected returns over a wide range of rates

In a base case where rates show no change over one year, 30-year pass-throughs easily beat portfolios of 2- and 10-year Treasury debt matched to the duration of each MBS. The order and magnitude of outperformance mirror the different spreads in each pass-through. At the low end, 30-year 2.0% pass-throughs show projected 1-year returns 49 bp higher than Treasury debt, and, at the high end, 30-year 5.5% pass-throughs show returns 145 bp higher (Exhibit 1).

Most pass-throughs hold their return advantage over shifts up or down in the yield curve of as much as 100 bp. Coupons 2.0% through 4.5% do underperform if rates shift higher by 100 bp. But coupons 5.0% and 5.5% continue to outperform through higher rates, the 5.5% coupon by a projected 33 bp.

Exhibit 1: Projected returns in 30-year pass-through net of returns in Treasury debt

Note: Data shows the performance in 30-year TBA MBS net of returns in a duration- and proceeds-matched portfolio of 2- and 10-year Treasury notes. All market levels as of COB 9/29/22. Total returns in all assets assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Returns do not account for dollar rolls. Calculation details in the appendix to this note.
Source: Yield Book, Amherst Pierpont Securities.

A pattern of returns where MBS performance against Treasury debt peaks in a base case and then fades in the wings is typical. Price performance in negatively convex MBS is worse than performance in positively convex Treasury debt as rates shift. And big shifts in rates eventually offset the MBS spread and income advantage. The only difference currently is the strong initial outperformance of MBS and its ability to survive bigger shifts in rates.

Although MBS for most investors seems like better value than Treasury debt based on nominal spread, option-adjusted spread and projected total return, picking the right coupon is a tougher job for a few reasons:

Differences in spread risk
The possibility of fast prepayment speeds in lower coupons, and
The risk of Fed sales of MBS

Differences in spread risk

Investors have to weigh material differences in spread risk across 30-year pass-throughs. Sensitivity to changing MBS spreads varies from 7.40 years in 30-year 2.0%s to 4.54 years in 5.5%s. MBS spreads at current levels look more likely to tighten than not, but investors need to be ready to tolerate spread volatility.

Exhibit 2: Investors need to weigh differences in spread duration

Note: All market levels as of COB 9/29/22.
Source: Yield Book, Amherst Pierpont Securities.

Lower coupons may have more potential than models project

These projected returns may understate the potential in lower coupons. The 30-year 2.0%s, for example, closed on September 29 at $81-14, making them extremely sensitive to even small increases in prepayment speeds. The Yield Book model used in this analysis, and used by many MBS investors, shows a long-term CPR of only 4.3. Extensive earlier work at Amherst Pierpont (Trading MBS below par) suggests this coupon should prepay on average at 6 CPR, adding significantly to the effective spread and value of this coupon and to its total return.

The lingering risk of Fed sales

MBS investors also keep wrestling with the possibility of sales out of the Fed portfolio, which would disproportionately affect the 2.0%, 2.5% and 3.0% coupons that dominate the Fed portfolio. Fed Chair Powell downplayed the possibility at the September FOMC, but concerns continue. At this point, sales of MBS would pull a policy lever likely to add complexity to the Fed’s job while having limited impact on inflation. Sales look unlikely until late 2023, and then only in small amounts unlikely to distort the market.

15-year pools have less upside at higher coupons

Total returns of 15-year pass-throughs also increase at higher coupons, but the advantage is less than for 30-year pools (Exhibit 3). For example, the base-case one-year total return for 15-year MBS increases 33 bp from the 2.5% to 4.5% coupons, while 30-year MBS returns increase 42 bp over that same coupons. And 30-year coupons above 4.5%s offer even higher returns, but those coupons are not readily available in 15-year pools.

Exhibit 3: Projected returns in 15-year pass-through net of returns in Treasury debt

Note: Data shows the performance in 15-year TBA MBS net of returns in a duration- and proceeds-matched portfolio of 2- and 10-year Treasury notes. All market levels as of COB 9/29/22. Total returns in all assets assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Returns do not account for dollar rolls. Calculation details in the appendix to this note.
Source: Yield Book, Amherst Pierpont Securities.

At lower coupons, 15-year MBS offer a comparable return profile to 30-year MBS. For example, hedged total returns of FNCI 2.0%s underperform hedged total returns of FNCL 2.0%s at the base case and in small rate moves, but outperform in larger moves (Exhibit 4). However, 15-year pass-throughs have less exposure to the spread between mortgage and Treasury yields. That is an advantage for investors that worry about more spread widening but do not want to overweight higher coupons.

Exhibit 4: Projected returns in 2% 30-year and 15-year pass-through net of returns in Treasury debt

Note: Data shows the performance in 30-year and 15-year TBA MBS net of returns in a duration- and proceeds-matched portfolio of 2- and 10-year Treasury notes. All market levels as of COB 9/29/22. Total returns in all assets assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Returns do not account for dollar rolls. Calculation details in the appendix to this note.
Source: Yield Book, Amherst Pierpont Securities.

However, excess returns for 15-year pass-throughs fall behind returns for 30-year passthroughs at higher coupons. For example, the 15-year 4% coupon underperforms the 30-year coupon in all interest rate environments except a 100 bp increase (Exhibit 5).

Exhibit 5: Projected returns in 4% 30-year and 15-year pass-through net of returns in Treasury debt

Clear relative value

Investors still able to trade for relative value can add MBS at historically wide spreads, with liquidity second only to the Treasury market and with potential to deliver significantly better returns than Treasury debt. The relative value is clear.

An appendix to this note shows all the calculations used in estimating returns in 30- and 15-year pass-through and in the matched portfolios of Treasury debt.

APPENDIX

CALCULATIONS FOR 30-YEAR PASS-THROUGHS

FNCL 2.0%s

Note: All market levels as of COB 9/29/22. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Amherst Pierpont Securities.

FNCL 2.5%s

FNCL 3.0%s

FNCL 3.5%s

FNCL 4.0%s

FNCL 4.5%s

FNCL 5.0%s

FNCL 5.5%s

CALCULATIONS FOR 15-YEAR PASS-THROUGHS

FNCI 2.0%s

FNCI 2.5%s

FNCI 3.0%s

FNCI 3.5%s

FNCI 4.0%s

FNCI 4.5%s

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

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