By the Numbers

Likely excess return on high-coupon MBS near YTD high

| July 27, 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.

Projected excess returns for higher coupon MBS are approaching the highest levels of this year. Mortgage rates have been falling, lowering MBS convexity, and investors typically demand more yield as compensation. But the market has widened enough that FNCL 5.5%s and higher are projected to outperform lower coupons across parallel rate moves of up to 100 bp in either direction. FNCL 5.5%s offer a healthy return advantage over FNCL 5.0%s and lower coupons but have less refinancing risk than FNCL 6.0%s. Compared to conventional MBS, Ginnie Mae MBS offer a small return advantage in lower coupons, but lag conventionals up the stack.

The excess return advantage of higher coupons compared to lower coupons is approaching the highest levels of the year (Exhibit 1). This shows the excess return of FNCL 5.5%s over FNCL 2.5%s, using 2- and 10-year US Treasuries to create a proceeds- and duration-neutral portfolio. The 1-year excess return advantage started the year near 60 bp, but recently fell to as low as 20 bp. However, over the past few weeks it has rebounded to 55 bp annually.

Exhibit 1. The projected return advantage of higher coupons is approaching this year’s high.

Excess return of FNCL 5.5% vs FNCL 2.5%, after hedging duration using 2-year and 10-year UST.
Source: Yield Book, Santander US Capital Markets.

The higher return reflects investors demanding extra yield as compensation for heightened prepayment risk since mortgage rates have been falling. The peak at the start of the year also came when rates were relatively low. Returns were even high in April and May 2023, when many MBS investors were focused on the FDIC’s sales of securities it acquired from Silicon Valley Bank and Signature Bank of New York. Most of those pools were lower coupon, and demand for production MBS waned at that time.

The improved relative value of higher coupons is also evident in option-adjusted spreads (Exhibit 2). Low coupon OASs, like FNCL 2.5%s, have been tightening for a couple of months, while higher coupons like 6.0%s and 6.5%s have been slowly widening. And FNCL 5.5%s had been tightening along with 2.5%s but have gapped wider since early July.

Exhibit 2. Higher coupon option-adjusted spreads have widened relative to lower coupons OASs.

Source: Yield Book, Santander US Capital Markets.

Projected excess returns are positive across the stack in parallel rate moves up to 100 bp higher or lower (Exhibit 3). Two coupons stand out compared to the immediately lower coupon—the 5.5%s offer a healthy return advantage compared to 5.0%s, and the 6.0% coupon likewise is much higher than 5.5%s. Neither coupon has many loans that are in-the-money, but the 6.0%s are closer to refinanceable if rates were to rally. So, the 5.5% coupon may be the safer choice in the event rates drop and the model has underestimated speeds.

Exhibit 3. Conventional 30-year excess returns are positive in most rate scenarios.

Source: Yield Book, Santander US Capital Markets.

It is important to note that these excess returns do not include any special financing from the dollar roll. Currently the FNCL 3.5% roll is trading about 1/32s special and FNCL 2.0%s about 0.5/32s special, but otherwise conventional rolls are trading close to carry.

Swapping from FNCL 2.5% into FNCL 5.5% lifts projected yield, OAS, and one-year total returns (Exhibit 4). This trade keeps the net MBS exposure unchanged; it replaces $1 million FNCL 2.5%s with $1 million FNCL 5.5%. To keep the overall trade proceeds- and duration-neutral, the FNCL 5.5% is combined with 10-year UST and the FNCL 2.5% is combined with 2-year UST. The higher coupon position offers 36 bp higher yield, 8 bp higher SOFR OAS and 2 bp higher Treasury OAS. The base-case one-year total return is 55 bp higher and never falls below zero in the various parallel shift, steepener, and flattener scenarios.

Exhibit 4. Swapping from FNCL 2.5% to FNCL 5.5%.

Source: Yield Book, Santander US Capital Markets.

For investors that need to keep some exposure in lower coupons, Ginnie Mae MBS may be a way to pickup slightly better returns (Exhibit 5). Ginnies benefit from faster FHA and VA housing turnover and the market may currently be slightly undervaluing that advantage. But any differences in special financing is likely to overwhelm the total return differences. In higher coupons, Ginnies face greater prepayment risk than conventionals, primarily from VA loan refinancing. Projected returns in 6%s and 6.5%s are trailing conventionals as a result. Many higher Ginnie Mae coupon dollar rolls are currently special—for example, according to Yield Book as of 7/24, 5.5%s are 0.9/32s special, 6%s are 0.34/32s special, and 6.5%s are 2.5/32s special. This might tip the scales towards Ginnies over conventionals for investors that can take advantage of those rolls and and bear the added refi risk.

Exhibit 5. Ginnie Mae MBS trails conventional MBS in higher coupons.

Using production Yield Book. Ginnie Mae uses a -50 bp elbow shift to account for lower VA, and to a lesser extent FHA, mortgage rates.
Source: Yield Book, Santander US Capital Markets.

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

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.

The Library

Search Articles