Risk-adjusted carry looks better in higher coupons

Brian Landy, CFA | March 17, 2023

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.

Agency MBS spreads widened this week after the collapse of SVB and Signature Bank on concerns that some banks could sell MBS to finance deposit withdrawals despite actions taken by the Fed. Markets are also grappling with higher interest rate volatility and uncertainty about the Fed’s upcoming rate decision. Any bank sales would likely be concentrated in lower coupons, so MBS investors should consider moving up-in-coupon. Investors can earn positive one-month returns on FNCL 5.5%s through 6.5%s even after hedging curve risk with Treasuries and convexity risk with swaptions.

One-month total returns on MBS pass-throughs net of a replicating portfolio of Treasuries and swaptions is generally negative but turns positive for coupons 5.5% and higher (Exhibit 1a and 1b). Two bars are shown for each TBA coupon. The blue bar shows the projected 1-month return for an investor holding the TBA pass-through minus the return of the replicating portfolio. The red bar shows the additional return the investor can earn by dollar rolling the TBA one month. For 2%s through 5%s the roll is generally slightly special—the 2.5% roll is the exception—but not enough to shift the monthly return positive. The 5.5% through 6.5% coupons generate positive returns without rolling, and the dollar roll lifts that return higher. The 1.5% coupon dollar roll, however, is running extremely special, enough to shift the risk-adjusted return into positive territory.

Exhibit 1a: TBA 1-Month total returns net of curve and options hedges

As of 3/16/2023.
Source: Yield Book, Santander US Capital Markets.

Exhibit 1b: TBA 1-Month total returns net of curve and options hedges

As of 3/16/2023.
Source: Yield Book, Santander US Capital Markets.

The FNCL 6.0% TBA is a good example of how the replicating portfolio is constructed (Exhibit 2). The top row is a long position in FNCL 6.0%s with a $1,000,000 market value. The second row shows a swaption position in equal notional amounts of 1-month payer and receiver swaptions on the 10-year rate, known as a straddle, that pays the investor if rates move higher or lower. However, in small rate moves the premium paid for the options is greater than the payoff amount, so they generate negative return. The options are very convex, which compensates for most of the negative convexity in the TBA. The TBA convexity is -0.83 while the swaption convexity is +507.49; after buying $1,794 of the swaptions the net convexity is +0.08.

Exhibit 2: Hedging FNCL 6.0%s with Treasuries and swaptions

As of 3/16/2023. Total returns do not include special financing from the dollar roll.
Source: Yield Book, Santander US Capital Markets.

However, the combined TBA and swaption position still has lot of exposure to rate moves—the duration is 2.18 years. This can be hedged using short positions in 2- and 10-year Treasury notes, shown in the bottom half of the table. These are chosen to match the duration and convexity of the combined TBA+swaption position. Therefore, the combination of a long swaption and short Treasuries has replicated the market value, duration, and convexity of the TBA.

The monthly total returns show the benefit of these hedges. The TBA, unhedged and ignoring financing costs, has a base-case total return of 0.45%. That return jumps to 0.94% if rates fall 25 bp, and drops to -0.09% if rates increase 25 bp. The investor is highly exposed to rate moves, and the negative convexity of the TBA means the investor loses more (54 bp) when rates increase then the investor gains (49 bp) if rates fall. The net position, which assumes the investor does not dollar roll, returns 4 bp in the base case. But the swings are much smaller if rates move, and exhibit a small amount of residual positive convexity, increasing 4 bp if rates move up 25 bp and losing 2 bp if rates fall 25 bp. The 6% dollar roll is special, so an investor can add 4.6 bp to these returns by rolling the position.

This is a compelling alternative way to look at MBS relative value. It allows investors to price the curve risks inherent in an MBS position. An investor often uses option-adjusted spreads to look at relative value, but the OAS is a summary of all the risks of owning an MBS. It does not give information on the relative importance and cost of each of those risks, but the investor can gather that information from this approach and use it to guide MBS purchases and hedging decisions.