By the Numbers

Low coupon excess returns lead the way in May

| June 2, 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.

Excess returns in agency MBS shifted positive in May, reversing an underperformance that started in February. Low coupons led the way, and returns turned positive across the coupon stack. Ginnie Mae excess returns also turned up in May and similarly fared better in lower coupons. Most of the return came in a big jump at the end of the month, likely in response to the debt-limit deal. Before that, excess returns had trended slightly negative for most of May as the market absorbed heavy selling by the FDIC. Mortgage TBA and dollar roll trading volumes have been relatively stable despite the regional banking crisis.

Conventional 30-year excess returns turned positive across the coupon stack in May but are still negative year-to-date for all but 1.5%s (Exhibit 1). Mortgages had a strong start to the year, but things started to weaken in February. Then mortgages sharply underperformed in March when Silicon Valley Bank and Signature Bank failed, and generally edged lower through late May. Lower coupons had generally underperformed higher coupons, but the late May move has evened things out. For example, FNCL 2.5%s are down 32 bp compared to Treasuries through the end of May, while FNCL 5.5%s are down a similar 31 bp. But the 2.5%s added 30 bp of excess return compared to the 5.5%s in May.

Exhibit 1. Conventional 30-year MBS excess returns (%)

Excess returns reported by the Bloomberg Barclays MBS Index, through 5/31/2023.
Source: Bloomberg, Santander US Capital Markets

The story is similar for Ginnie Mae 30-year mortgage-backed securities (Exhibit 2). The 2.0% and 2.5% coupons posted higher excess returns than the rest of the coupon stack in May, and no coupons had negative excess returns. However, low coupon Ginnies have outperformed higher coupons year-to-date, and a the 2.0%s and 3.0%s now have slightly positive excess returns for the year.

Exhibit 2. Ginnie Mae 30-year MBS excess returns (%)

Excess returns reported by the Bloomberg Barclays MBS Index, through 5/31/2023.
Source: Bloomberg, Santander US Capital Markets

TBA trading volume is holding steady

Mortgage TBA trading volumes have held relatively steady this year, despite the market disruption in March and the commencement of the FDIC’s asset sales in April (Exhibit 3). Trading activity fell throughout 2021 and 2022 as refinance activity slowed but appears to have leveled off in 2023. The light-blue line attempts to show the trend in trading volumes after removing the intra-month seasonality. The trend has been range-bound since the middle of 2022. There was a small pickup last fall, followed by a small slowdown in the winter when homebuying slows, and then a bit of a recovery in early 2023. But all those moves are small compared to the levels reached during the pandemic.

Exhibit 3. TBA trading volume

The dark blue line is weekly trading volume, the light blue trend line is extracted using a Christiano-Fitzgerald filter.
Source: Federal Reserve, Santander US Capital Markets

Dollar roll activity has also stabilized since mid-2022 (Exhibit 4). Use increased during the pandemic, then slowly fell as refinance activity subsided. Levels were remarkably steady from the spring of 2022 through the end of that year. There was a small dip lower in March and April, likely due to the regional banking crisis. But it has since rebounded back to the levels seen in 2022. Dollar rolls traded special throughout much of the pandemic due to heavy demand for mortgage-backed securities by the Fed and banks, but rolls weakened when the Fed and banks stopped adding MBS to their portfolios.

Exhibit 4. Dollar roll usage has held steady since spring 2022.

The dark blue line is weekly trading volume, the light blue trend line is extracted using a Christiano-Fitzgerald filter.
Source: Federal Reserve, Santander US Capital Markets

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

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