By the Numbers

Tighter MBS spreads, but good prospective returns

| June 23, 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.

MBS spreads have tightened significantly since mid-to-late May, reflecting healthy demand for mortgages sold by the FDIC and the end of the US debt ceiling showdown. Despite the tightening, mortgages still offer higher projected total returns than a portfolio of US Treasury notes with the same market value and duration. Ginnie Mae MBS show higher projected returns than conventional MBS in coupons 4.0% and higher while 15-year MBS underperform 30-year MBS except in very large rate moves.

Mortgage option-adjusted spreads (OAS) widened from early March until mid-April in after the failures of Silicon Valley Bank and Signature Bank, but not all coupons followed the same path (Exhibit 1). FNCL 2.5%s and FNCL 5.0%s, for example, maintained relatively similar OASs until mid-April, when the FDIC began selling the MBS assets held by the two failed banks. Once selling began, the 2.5%s outperformed the 5.0%s, despite the selling being concentrated in lower coupons like 2.5%s. Demand for higher coupons may have dropped while investors focused on the sales. And for a short time, investors were concerned the Fed might need to start cutting interest rates. Higher coupons have outperformed since the debt limit agreement was reached, and the gap between low coupon and high coupon option-adjusted spreads has narrowed.

Exhibit 1. The difference between option-adjusted spreads across coupons is narrowing.

Source: Yield Book, Santander US Capital Markets

Higher-coupon mortgage-backed securities still show higher projected excess total returns over the next year than lower-coupon securities (Exhibit 2). For each coupon a portfolio is constructed using 2- and 10-year Treasury notes with the same combined market value and duration as that coupon’s TBA. Details are shown in the appendix. The graph shows the excess projected 1-year total return of each TBA over its matching Treasury portfolio for a variety of interest rate scenarios. The base return is largest for the highest coupons in the stack; the recent tightening has reduced, but not eliminated, the up-in-coupon advantage.

Exhibit 2. Projected 1-year excess returns for conventional 30-year TBA

Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

The base returns are high enough to offset much of the effect of negative convexity. For most coupons, the projected returns only fall below the Treasury position if rates increase more than 75 bp. The returns depend on the accuracy of the prepayment model, of course. If prepayment speeds increase more than expected as rates drop, then returns would come in lower than projected. This risk is more acute for higher coupons. However, the projected return is greater than 1.0% for FNCL 5.0%s and over 1.25% for FNCL 5.5%s even if rates were to fall 100 bp, which provides a nice cushion against model error.
Projected returns for 15-year MBS are generally lower than for 30-year MBS (Exhibit 3). This chart shows the difference between the excess return of each 15-year MBS and the matching coupon 30-year MBS. The 15-year MBS offer better convexity, so performance improves as rates increase or decrease. However, most coupons underperform 30-year MBS even if rates move 100 bp higher or lower. Only the 15-year FNCI 4.5%s materially outperform FNCL 4.5%s if rates move 100 bp, and the FNCI 4.0%s materially outperform FNCL 4.0%s only if rates fall 100 bp.

Exhibit 3. Projected returns are generally lower for 15-year conventional MBS than 30-year MBS.

Difference between excess returns of 15-year MBS and excess returns of 30-year MBS. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

Ginnie Mae mortgage-backed securities should outperform conventional MBS in 4.0% and higher coupons (Exhibit 4). Each of those G2SF coupons is projected to outperform the corresponding 30-year MBS for all the shown rate scenarios. The excess return profile for the 4.5% and 5.0% coupons is quite stable across different interest rates. The 4.0% and 5.5% coupons show a little more rate sensitivity, but both are positively convex compared to the matching conventional MBS and also outperform conventional across wide interest rate moves.

Exhibit 4. Ginnie Mae 4%s and higher are projected to outperform conventional MBS.

Difference between excess returns of 30-year Ginnie Mae MBS and excess returns of 30-year conventional MBS. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

The appendix shows the matching portfolio and analytics of each FNCL, FNCI, and G2SF coupon.

APPENDIX

FNCL 2.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Source: Yield Book, Santander US Capital Markets.

FNCL 2.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 3.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 3.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 4.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 4.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 5.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 5.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCL 6.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 2.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 2.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 3.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 3.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 4.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 4.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Source: Yield Book, Santander US Capital Markets.

G2SF 5.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

G2SF 5.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Source: Yield Book, Santander US Capital Markets.

G2SF 6.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 1.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Source: Yield Book, Santander US Capital Markets.

FNCI 2.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 2.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 3.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 3.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 4.0%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR.
Source: Yield Book, Santander US Capital Markets.

FNCI 4.5%s

Note: All market levels as of COB 6/21/2023. Total returns assume a linear parallel shift in rates and constant OAS repricing at horizon, reinvestment in 1-month SOFR. Source: Yield Book, Santander US Capital Markets.

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

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