By the Numbers

Another look at MBS through the lens of hedged returns

| December 1, 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.

The differences between option-adjusted spreads for MBS has narrowed across coupons over the last few months. Lower coupon OASs have generally trended wider while higher coupons have generally tightened. Moving up-in-coupon boosts return at the expense of added negative convexity but projected 1-year total returns stay positive even after hedging duration across the coupon stack. And mortgage spreads are wide enough that 1-month carry is positive for most coupons after hedging duration and using swaptions to hedge convexity. Conventional 30-year MBS has higher projected total returns than 15-year MBS in most coupons and rate scenarios. Ginnie Mae 30-year MBS outperforms conventional in higher coupons and underperforms in lower coupons, but the gap is narrow.

The difference between the OAS of high and low coupon MBS has narrowed over the last few months (Exhibit 1). At the start of September, the gap between FNCL 6.5%s and FNCL 2.5%s was 39 bp and that has fallen to roughly 9 bp. The lowest OASs are currently in the middle of the coupon stack—3.5%s to 5.5%s—and the OAS gap is only about 16 bp between those coupons and 6.5%s. Lower coupons generally widened more than higher coupons tightened, indicated overall mortgages have become cheaper.

Exhibit 1. Conventional 30-year OAS differences have narrowed.

Source: Yield Book, Santander US Capital Markets

Projected excess returns still favor higher coupons, which has been true for much of the year (Exhibit 2). This chart shows the one-year total return projected by Yield Book for each coupon TBA minus the return of a duration- and proceeds-neutral portfolio of 2- and 10-year Treasuries. Projected excess returns increase steadily in the base case moving up the coupon stack. Excess returns are positive for almost every TBA in every rate scenario. The sole exception is FNCL 4%s if rates increase 100 bp. Higher coupons have more negative convexity, which is apparent in the graph—projected returns fall if rates change and fall the most for higher coupons.

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

Note: All market levels as of COB 11/29/2023. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

Hedging convexity with a swaption straddle can help show whether the investor is being adequately compensated for risk of the MBS (Exhibit 3). This table shows the 1-month carry of each MBS over the carry of a duration-, convexity- and proceeds-neutral portfolio of 2- and 10-year Treasuries and the 1M×10Y swaption straddle. The MBS has a higher carry in all but one coupon, and that coupon only falls behind by 0.1/32s. Carry increases across the board if rates fall and increases in higher coupons if rates go up. Carry turns negative in lower coupons if rates were to increase. Moving up-in-coupon looks more attractive, especially in 6%s and 6.5%s, but the return profile for lower coupons has improved as spreads widened.

Exhibit 3. Projected one-month carry after hedging duration with 2Y and 10Y UST and convexity with 1M×10Y swaptions (32s).

Note: All market levels as of COB 11/29/2023. Returns do not include any special financing from dollar rolls. See appendix for trade details.
Source: Yield Book, Santander US Capital Markets.

Home prices are likely to have a large influence on MBS prepayment next year, since most prepayments will come from housing turnover. States with higher HPA tend to have faster turnover, and this advantage is larger in higher coupons. Higher coupons also make sense for investors concerned about spreads, since they have lower spread durations. Mortgage spreads are likely to be volatile again next year as private investors are more concerned with relative value to other asset classes and money managers must worry about redemptions. The stability provided by heavy investment from the Fed and banks is not likely to return.

Projected total returns are lower for 15-year MBS than 30-year MBS in almost every scenario (Exhibit 4). This shows the excess return of the 15-year TBA over a 30-year TBA with the same market value, and duration hedged by a combination of Treasuries.

Exhibit 4. Projected returns are lower for 15-year conventional MBS than 30-year MBS.

Note: All market levels as of COB 11/29/2023. 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 MBS have slightly higher projected total returns than conventional 30-year MBS (Exhibit 5). The advantage is somewhat greater in higher coupons. However, the G2SF 6.5%s are projected to have much higher returns if interest rates were to increase, reflecting the potential for faster turnover from FHA and VA loans and refinance risk in that coupon recedes.

Exhibit 5. Ginnie Mae MBS are generally projected to outperform conventional MBS.

Note: All market levels as of COB 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 6.5%s

Note: All market levels as of COB 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 6.5%s

Note: All market levels as of COB 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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 11/29/2023. 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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