By the Numbers

Lower spread and rate risk with 15-year MBS

| March 31, 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.

Investors concerned about wider spread in low-coupon pass-throughs should consider moving into 15-year MBS. The market remains concerned that the FDIC could sell assets from Silicon Valley Bank’s held-to-maturity portfolio, which likely holds a large amount of 30-year MBS issued in 2020 and 2021. In low coupons, replacing 30-year MBS with the same coupon and market value 15-year MBS and hedging the duration difference with 2- and 10-year Treasury notes has the same carry if rates stay the same but adds convexity. Investors that can dollar roll also benefit from better carry in the 15-year roll market. Lower spread duration should also protect investors if there are big sales from the SVB portfolio.

One-month carry for a portfolio of 15-year MBS and 10-year Treasury notes is close to carry for a replicating portfolio of 30-year MBS and 2-year Treasury notes in 1.5%s, 2.0%s, and 2.5%s (Exhibit 1). The portfolios are constructed such that the two MBS have the same market value, the two Treasury notes have the same market value, and each portfolio has the same duration. Two bars are shown for each TBA coupon. The blue bar shows the projected 1-month carry for an investor holding the FNCI+10-year combo minus the return of the replicating portfolio. The red bar shows the additional carry the investor can earn by dollar rolling the FNCI one month minus the carry lost by not rolling the 30-year MBS. Stronger 15-year dollar rolls lift 15-year carry across the stack and push the carry positive for all but the 3.0% and 5.0% coupons.

Exhibit 1a. FNCI – FNCL 1-month carry net of duration hedge.

As of 3/29/2023.
Source: Yield Book, Santander US Capital Markets
.

Exhibit 1b. FNCI vs. FNCL 1-month carry net of duration hedge.

As of 3/29/2023.
Source: Yield Book, Santander US Capital Markets
.

Investing in 15-year MBS instead of 30-year MBS in these coupons should benefit investors if bonds are sold from the SVB portfolio. Those holdings are likely concentrated in low coupon 30-year MBS, holding 15-year MBS might avoid any widening that results from those sales. But even if 15-year spreads were to widen, the lower spread durations will provide some protection for investors.

Moving into 15-year MBS also allows the investor to add convexity, which is helpful when rate volatility is high. This helps the 15-year position to carry better than the 30-year position if interest rates move (Exhibit 2). For example, the FNCI 3.5% adds 0.5/32s of carry if rates were to increase 25 bp and would add 1.6/32s if rates were to increase 50 bp. The 15-year position does very well in bull steepener and flattener scenarios; but underperforms in a bear flattener.

Exhibit 2. FNCI vs. FNCL 1-month carry net of duration hedge, rate scenarios.

As of 3/29/2023. Carry does not include special financing from the dollar roll.
Source: Yield Book, Santander US Capital Markets
.

For longer holding periods, however, the 15-year position underperforms the 30-year position (Exhibit 3). The better convexity of the 15-year MBS does help in large rate moves of around 100 bp but isn’t enough to overcome the base-case underperformance for smaller rate moves. The 15-year position also does well in a bull steepener.

Exhibit 3. FNCI vs. FNCL 1-year total returns net of duration hedge.

As of 3/29/2023. Total returns do not include special financing from the dollar roll. Interest rates shift linearly over the 12-month horizon.
Source: Yield Book, Santander US Capital Markets
.

The 2.5% coupon provides a useful example of how the trade works (Exhibit 4). The trade goes long $1,082,407 FNCI 2.5%s and short $1,165,278 of FNCL 2.5%s; each has a market value of $1,000,000 so the trade is proceeds-neutral. However, the trade has a negative duration, which can be offset by buying $404,021 10-year notes and selling $403,451 2-year notes. That gives the long and short side of the trade the same market value and duration.

Exhibit 4. FNCI 2.5% & 10-year notes vs. FNCL 2.5% & 2-year notes.

As of 3/29/2023. Carry does not include special financing from the dollar roll.
Source: Yield Book, Santander US Capital Markets
.

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

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