By the Numbers

Wide bid-ask spreads challenge MBS investors

Brian Landy, CFA | May 5, 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.

The bid-ask spread for TBA MBS has lately reached its highest level in at least two years. This is likely due to lower MBS demand from the Fed and banks, the uncertainty surrounding the viability of certain regional banks and the Federal Deposit Insurance Corporation’s sales of MBS acquired from Silicon Valley Bank and Signature Bank. Investors may find the heavy costs makes it difficult to take advantage of MBS opportunities, like reallocating to different coupons or shifting between 15-year and 30-year MBS.

The bid–ask spread for the current coupon TBA has ranged from 3/32s to 6/32s for most of 2023 (Exhibit 1). The chart shows the bid–ask spread for the MBS coupon priced closest to, but higher than, par. Prior to late 2022, the bid–ask spread was typically around 1/32 and rarely exceeded 2/32s. Anecdotally, this might be the widest bid–ask since the 2008 financial crisis, but unfortunately the data does not go back that far.

Exhibit 1. TBA Bid–Ask spreads are at the widest levels in over two years.

Moving average applied to smooth day-to-day noise. The current coupon bid–ask spread is determined by choosing the spread of the coupon with the lowest price at or above par each day. Data as of 5/3/2023.
Source: Bloomberg, Santander US Capital Markets.

The current coupon spread first widened last spring, around the time the Fed stopped buying agency MBS pools. It widened from roughly 1/32s to 2.5/32s by the end of May, when the Fed started to allow its MBS portfolio to runoff. The spread stayed at that level for a few months, then tightened back to 1/32s until December. The bid–ask widened sharply in December, and then shifted even wider in February as the banking crisis developed, peaking around the time of the Silicon Valley Bank and Signature Bank failures. It narrowed a little after then but has shifted wider over the last couple of weeks as the FDIC began auctioning off pieces of the SVB and Signature MBS portfolios.

Mortgage rates increased sharply in 2022. By September, the MBS current coupon had moved above 5% and ranged from 5% to 6% for most of the time since then. Therefore, the current coupon bid–ask does not reflect movements in lower coupons. But lower coupons’ bid–ask also widened (Exhibit 2). This shows the spread for FNCL 2%s and FNCL 2.5%s, which became less liquid as origination in those coupons dried up. The 2%s spread jumped sharply wider, to over 5/32s, in December and has stayed in that neighborhood since then. The FNCL 2.5% spread increased into the 3/32s to 4/32s area, and occasionally has breached 5/32s.

Exhibit 2. Bid-ask spread for lower coupons have also jumped.

Moving average applied to smooth day-to-day noise. Data as of 5/3/2023.
Source: Bloomberg, Santander US Capital Markets.

The mortgage market is not alone in dealing with a wider bid-ask and other markers of lower liquidity. Liquidity in the Treasury market started eroding in late 2021 as the Fed signaled a hiking cycle and then eroded sharply as the Fed chased inflation through 2022 with a series of 75 bp hikes—hikes that created broad uncertainty about the economy and Fed policy and triggered sharp swings in yields. This shows up clearly in the rising dispersion of intraday yields across on-the-run and off-the-run Treasury issues (Exhibit 3).

Exhibit 3: Rising illiquidity in Treasury debt roughly tracks rising bid-ask in MBS

Note: The index reflects the average difference in yield between US Treasury issues with a 1-year or longer maturity and the intra-day Bloomberg relative value curve fitter. In liquid markets, deviations go away quickly, and index values are low. In illiquid markets, deviations persist, and index values are high.
Source: Bloomberg, Santander US Capital Markets LLC.

The wide bid–ask spread is challenging for MBS investors. Among other things, it becomes more costly to rebalance the coupon exposure of MBS portfolios. Investors might need to do that to track the index, to take advantage of opportunities in different parts of the coupon stack, or to take advantage of dislocations between 15-year and 30-year MBS. The high transaction costs imposed by the wide bid–ask spread can wipe out the profit in some of those trades. It also becomes more costly to trade specified pools at a price spread to TBA since the price of the TBA can vary so widely. In general, wide bid-ask is slowing the reallocation of capital based on risk and relative value and contributing to wider spreads in the sector.

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

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