By the Numbers

Improved relative value in lower-coupon MBS

Brian Landy, CFA | March 1, 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. This material does not constitute research.

Lower-coupon agency MBS underperformed last week after Truist Financial Corp. announced plans to restructure its available-for-sale portfolio. The bank seems likely to sell lower-coupon Fannie Mae and Freddie Mac MBS, possibly replacing them with production-coupon Ginnie Mae MBS. The underperformance improved relative value in these lower coupons. Investors that own Freddie Mac CMBS, for example, can add as much as 75 bp to projected base case 1-year total returns by shifting into agency specified pools or TBA. Investors would also pick up better liquidity and, if invested in TBA, the possibility of special financing in the dollar roll market.

Strongest projected performance in specified pools

Projected 1-year total returns on 30-year pools backed by loans with low loan balances come in as much as 75 bp higher than a blend of Freddie Mac K Deal CMBS (Exhibit 1). Returns on loan-balance pools with a 3.0%, 3.5% or 4.0% coupon all top projected returns on a duration-matched blend of Freddie Mac K securities. Each MBS represents a pool that contains loans with original loan size of at most $225,000. The CMBS comparison is combination of 5- and 10-year Freddie K securities. An appendix to this note shows projection details. The return advantage is strongest with no or only modest moves in rates and then declines with bigger moves, reflecting the greater negative convexity of the pools. But the specified pools still outperform in parallel shift rate scenarios that range from 100 bp lower to 100 bp higher.

Exhibit 1: FNCL 3% to 4% Max $225k pools top projected TRR on Freddie Ks.

Projected 1-year excess returns of FNCL specified pools vs. a proceeds- and duration-neutral portfolio of Freddie Mac K bonds. The specified pools contain loans with no more than $225,000 original loan balance. Details are in the appendix. All market levels as of 27 Feb 2024 close from BVAL. Investors in specified pools generally cannot take advantage of special dollar roll financing.
Source: Yield Book, Santander US Capital Markets

TBA also outperforms and adds liquidity and possible special financing

Some investors prefer the liquidity of the agency TBA market. TBAs also outperform proceeds- and duration-neutral portfolios of Freddie Ks, although not by as much as the specified pools (Exhibit 2). For example, the 3.0%s and 3.5%s peak at close to 50 bp projected excess return over the corresponding CMBS portfolios, while the FNCL 4.0% reaches 61 bp excess return. The TBA also have more negative convexities, which causes excess returns to fall more in large rate moves. The TBAs are projected to underperform if rates increase more than 75 bp but are projected to outperform in the other scenarios. But these projected return miss an important attribute of TBA: the possibility of special financing.

Exhibit 2. FNCL 3% to 4% TBA pools show lower, more limited excess TRR.

Projected 1-year excess returns of FNCL TBA vs. a proceeds- and duration-neutral portfolio of Freddie Mac K bonds. Details are in the appendix. All market levels as of 27 Feb 2024 close from BVAL. Total returns do not include the potential for special dollar rolls.
Source: Yield Book, Santander US Capital Markets

One benefit to investing in TBA is access to special financing provided by the dollar roll market. Occasionally demand for MBS is high and investors can earn a higher rate of return from rolling positions than they can from holding pools and earning the carry. The total returns projected here do not account for the possibility of special financing. Investors in specified pools will typically not dollar roll those positions since the investor’s pool would likely be replaced with a different pool with lower convexity.

It is likely that most of the bonds Truist sells will be in the 2.0% and 2.5% coupons produced en masse during the Covid refinance wave. Banks were heavy buyers of those securities. Option-adjusted spreads on coupons as high as 4.5%s jumped wider after the Truist announcement. However, the 3.0% and higher coupons may be less likely to face more spread widening when the sales commence.

Details of all securities and return projections are in the appendix.

APPENDIX

Exhibit 3. FNCL 3.0% 2020 Max $225k vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Specified pools do not benefit from special dollar rolls.
Source: Yield Book, Santander US Capital Markets

Exhibit 4. FNCL 3.5% 2020 Max $225k vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Specified pools do not benefit from special dollar rolls.
Source: Yield Book, Santander US Capital Markets

Exhibit 5. FNCL 4.0% 2022 Max $225k vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Specified pools do not benefit from special dollar rolls.
Source: Yield Book, Santander US Capital Markets

Exhibit 6. FNCL 3.0% vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Total returns do not include potential for special dollar rolls.
Source: Yield Book, Santander US Capital Markets

Exhibit 7. FNCL 3.5% vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Total returns do not include potential for special dollar rolls.
Source: Yield Book, Santander US Capital Markets

Exhibit 8. FNCL 4.0% vs 5Y and 10Y Freddie Ks.

All market levels as of 27 Feb 2024 close. Indicative prices from BVAL. Total returns do not include potential for special dollar rolls.
Source: Yield Book, Santander US Capital Markets

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

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