By the Numbers

Up-in-coupon, into Ginnie Mae for projected return

| January 5, 2024

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 trying to maximize returns on MBS should consider shifting into higher coupons. Both option-adjusted spreads and projected returns make the case. OAS are wider in higher coupons, and those coupons look likely to generate higher excess returns than lower coupons. Excess returns in higher coupons outperform lower coupons even in 100 bp rate moves, suggesting the market may be overestimating prepayment risk in high coupon MBS. Ginnie Mae OAS are wider than conventional OAS in high coupons and have a better dollar roll, offering an additional lift to potential returns, while conventional MBS generally performs better in lower coupons.

OAS for conventional and Ginnie Mae MBS trend wider at higher coupons (Exhibit 1). The widest spreads for conventional and Ginnie Mae MBS are available in 5.5%s and higher. Conventional spreads are tightest in 3.5%s and 4.0%s and widen a bit in lower coupons, while Ginine Mae spreads are relatively similar in 4.5% and lower coupons. Higher coupon spreads were wider for much of 2023, but the gap narrowed throughout the fall as demand for low coupon MBS faltered. However, over the last couple of weeks the gap between high and low coupons resumed widening. The wider OAS at higher coupons may indicate that the market thinks those coupons have more negative convexity than Yield Book’s model forecasts.

Exhibit 1. Conventional 30-year option-adjusted spreads.

Source: As of COB 1/3/2024. Yield Book, Santander US Capital Markets

Ginnie Mae MBS OAS also are wider than conventional OAS across much of the coupon stack. Ginnie Mae MBS typically have more negative convexity than conventional since VA borrowers tend to refinance quickly. But many Ginnie Mae loans are FHA loans that typically refinance more slowly than conventional but turnover faster. The wider OASs suggest the market may be overestimating the negative convexity of Ginnie Mae pools relative to conventional. On the other hand, it could be that the model is underestimating how fast Ginnie pools could get in a refinancing wave. Policy risk is another potential difference between Ginnie Mae and conventional pools, but the prospects for disruptive changes in the government loan programs seems low.

Moving up-in-coupon, like the OAS indicate, lifts projected excess returns (Exhibit 2). This example compares a combination of FNCL 5.5% and 10-year Treasuries to a combination of FNCL 5.0% and with 2-year Treasuries. The overall portfolio is proceeds-neutral and duration-neutral, and the MBS positions each have the same market value to keep the MBS exposure unchanged. The FNCL 5.5% position has a higher yield, OAS, and convexity than the FNCL 5.0%, and higher projected total returns across 100 bp parallel shifts in either direction and various steepener and flattened scenarios. The FNCL 5.5% also has lower spread duration than the FNCL 5.0%, which may be attractive to investors concerned that spread volatility will remain high this year.

Exhibit 2. The FNCL 5.5% has higher projected returns than the FNCL 5.0% after matching market value and duration.

Note: All market levels as of COB 1/3/2024. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

A similar comparison between FNCL 5.5%s and FNCL 3.0%s shows that higher coupons also are projected to outperform much lower coupons (Exhibit 3). In this case the two MBS have similar option-adjusted spreads, yet the higher coupon still outperforms on yield and total durations and has a lower spread duration. The FNCL 5.5% does have lower convexity, which is apparent in the total returns, yet even in the extreme rate moves the FNCL 5.5% is projected to outperform the FNCL 3.0%. The total return advantage declines more if rates move higher but increases if rates fall, suggesting either the market overestimates the refinanceability of the FNCL 5.5% or that Yield Book is underestimating speeds. However, there is substantial cushion in those returns in case the model proves wrong.

Exhibit 3. The FNCL 5.5% has higher projected yield and total returns than the FNCL 3.0% after matching market value and duration.

Note: All market levels as of COB 1/3/2024. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

In higher coupons, Ginnie Mae MBS have higher projected returns than the equivalent conventional MBS (Exhibit 4). The G2SF does have slightly lower convexity and the total return advantage erodes more quickly in a rally. However, it is still positive across all the rate scenarios. These comparisons do not include any consideration of special financing from dollar rolls. Conventional rolls are currently not special in most coupons but Ginnie Mae rolls are special, so an investor swapping into Ginnies may be able to lift returns further by using dollar rolls.

Exhibit 4. G2SF 5.5% has higher projected total returns than FNCL 5.5%.

Note: All market levels as of COB 1/3/2024. Returns do not include any special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets

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

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