By the Numbers
Choices for rolling out of longer corporates into MBS
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.
Total return managers facing tight spreads at the longer end of the corporate term curve can find some alternatives in MBS. Last-cash-flow PACs offer the most meaningful advantage over a duration-neutral basket of highly rated corporate exposures. But there are other items on the menu.
Over the past two years, a heavy allocation to corporate exposures for portfolios benchmarked to an aggregate fixed income index has paid dividends for total return managers. However, those allocations have helped drive substantial spread-tightening across most sectors of the investment grade market, particularly in the longer end of the term curve. Tight spreads in longer duration corporates could drive a rotation out of certain corporate exposures into discount MBS pass-throughs or longer-duration CMOs.
Sizing up spreads
Looking at spot spreads across various corporate, MBS and structured product exposures compared to the distribution of those spreads over a 5-year lookback period shows that MBS and structured products are at the wider end of those distributions while corporate exposures are substantially tighter (Exhibit 1).
Exhibit 1: Corporate spreads at tight end of historical range
Note: Data shows current OAS as a percentile of each sector’s 5-year OAS range. A spread at 100% represents the widest level for a sector, 0% the tightest.
Source: Santander US Capital Markets, Bloomberg LP
Some of the widest spreads are observed in ABS and CMBS. Wide spreads in ABS should facilitate a rotation out of short-duration corporates into ABS but there are limited options in terms of longer duration ABS surrogates for corporate exposures. Private-label CMBS provides comparable duration to longer duration corporates but fundamentals underpinning CMBS valuations may drive more long duration dollars into agency MBS versus private label CMBS. Relative cheapness in both Ginnie Mae and conventional MBS spreads should translate to attractive relative value opportunities compared to corporates, particularly in instruments backed by current coupon cohorts which trade at substantially wider nominal spreads than discount MBS.
Framing relative value
Framing the value proposition of a rotation out of corporates into MBS involves comparing a basket of highly rated corporate exposures to discrete longer duration MBS exposures on a duration- and proceeds-neutral basis, which generally requires a blend of MBS and Treasuries to match the duration of the corporate basket. From there the MBS and Treasury exposure can be evaluated in terms of yield, nominal and option-adjusted spread and total return across parallel and non-parallel shifts in the yield curve.
Employing this framework shows that across discount TBA, specified pool and longer duration CMOs, discount last cash-flow PACs offer the largest advantage over corporates in terms of total return while fuller coupon Ginnie Mae last cash flows backed by 100% FHA collateral offer the biggest OAS pick (Exhibit 2).
Exhibit 2: Stacking up MBS returns, spreads versus corporates
Source: Santander US Capital Markets, Yieldbook
Note: Screening criteria for corporate basket as follows, 7- to-10-year duration, AA/high single A rating, index component. Sectors include retail, pharma, TMT, financials. Duration neutrality of MBS position versus corporate basket is achieved using on-the-run 10-year note to extend duration and on-the-run- 1-month Treasury bill to curtail duration.
Digging in on performance across scenarios, discount PACs, specifically stripped-coupon PACs backed by premium conventional loan balance collateral offer both the biggest yield pickup versus the corporate basket and substantial outsized total return into a rally. This comes from the combination of discount accretion coupled with the fact that the bond will hold duration into a rally as a result of more positively convex loan balance collateral. For investors looking to position for a bull steepening of the yield curve, full-coupon Ginnie Mae last cash flows backed by 100% FHA 6.0% pools offer both the largest pick in OAS versus the basket of corporate exposures as well as the largest total return advantage into a 50 bp bull steepening.
Conversely, the prospects for a rotation out of corporates into discount MBS, particularly TBA, look less promising. A duration-neutral exposure to TBA 2.5% versus the corporate basket offers a modest total return advantage into a rally or modest rise in interest rates and underperforms the basket into a 100 bp parallel shift up in rates as well as a bulls steeping scenario. Similar performance is observed in discount specified pools and higher coupon Z bonds.
And while it appears certain MBS exposures offer compelling alternatives to highly rated corporates, there are considerations that may make corporate allocations somewhat sticky. Managers may be somewhat reluctant to sacrifice some element of liquidity in corporate issues with large floats to rotate into CMOs. Additionally, there may be some momentum associated with ‘letting your winners run’ that may be a deterrent to a migration out of corporates into MBS. With that said, inflows into fixed income mutuals may certainly find their way into MBS versus corporates given the relative value proposition.
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