By the Numbers
Valuing pay-up convexity across specified pools
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.
As both the cost of call protection and interest rate volatility increase, investors may want to approach relative value using relationships between pay-ups for different coupons within specified stories. The ‘pay-up convexity’, when positive, identifies stories that have more upside than downside when rates move in opposite directions. A combination of pay-up convexity and OAS advantage over TBA as the primary drivers of relative value point to LLB and MLB 4.5% pools as among the best spots in the market.
Looking at pay-up convexity and OAS points to a few promising spots:
- LLB and MLB 4.5%s offer the greatest nominal pay-up convexity across all specified pool stories
- 5% and 4.0% cohorts offer positive pay-up convexity across most loan balance cuts
- Away from loan balance, investors can find positive pay-up convexity in 100% New York 3.0% and 4.0% pools and investor 3.0% pools
- Certain 6.5% loan balance cuts, specifically 150,000 to 200,000 max pools, offer positive pay-up convexity and the largest OAS pick up relative to TBA
Pay-up convexity?
Pay-up convexity uses the price premium on existing specified pools to look at price upside and downside as rates move. The fundamental tenet of the framework is that in a 50 bp drop in mortgage rates the pay-up in each cohort will approach the pay-up of the coupon 50 bp higher, and in a 50 bp rise in mortgage rates the pay-up will approach the pay-up of the coupon 50 bp lower. Positive pay-up convexity occurs when the pay-up increases more in one direction than it deceases in the other direction.
The ’shape’ of specified pool pay-ups
The idea of pay-up convexity is most intuitive for specified pool stories that offer call and extension protection. These stories should have a pay-up curve that peaks when deeply in or out-of-the-money and is at its trough for coupons close to par. The pay-up convexity will be positive near par because the pay-up increases in either direction. But pay-up convexity can also be positive for stories that only offer call protection, since the pay-up cannot fall below zero for TBA-deliverable pools. Near par, the pay-up should be close to zero but increase for premium coupons. That means there is more potential upside if rates fall than downside if rates increase, and that is positive convexity.
Exhibit 1: Seasoning adjusted pay-ups across loan balance and 100% NY specified pools
The adjusted pay-up equals the pay-up for the specified pool type minus the pay-up for generic pools of the same vintage.
Source: Santander US Capital Markets, Bloomberg LP
Pay-ups for 100% NY pools can trade well below generic pools in deep discount coupons given the frictions to associated with the state’s mortgage recording tax. This tax, which ranges from 1.0% to 1.5% in most areas, but can reach 1.8% to 2.8% in and around New York City, is an impediment to purchasing a home with a mortgage or refinancing a mortgage. The frictions to refinancing push the pay-up above zero for higher coupons Conversely, LLB and MLB pools, which historically have exhibited a flat S-curve, have higher pay-ups in deep discount coupons compared to coupons closer to par, with even higher pay-ups on premium coupons. The fact that pay-ups are neither directional nor linear facilitates the ability to look at these relationships to distill potential positive pay-up convexity.
Valuing the universe of specified pool stories
Pay-ups across specified stories can often be multidimensional and an attempt to employ a framework that is inclusive of all characteristics that drive pay-ups, particularly seasoning, would result in an unwieldy number of potential cohorts for some specified stories. To simplify the analysis, pay-ups for various vintages across stories were re-struck lower by the attendant cheapest-to-deliver pay-up that is indicative of seasoning in isolation. After adjusting for seasoning, the universe of specified pool pay-ups can be characterized by the following observations:
- Loan balance stories generally see a steep drop off in discount pay-ups for cuts $200,000 or greater.
- FICO, LTV and Florida collateral generally exhibit modest but balanced pay-ups in both deep discounts and higher premiums.
- 100% New York and non-owner-occupied stories show directionally higher pay-ups from discounts to premiums.
- Conversely, 100% Texas stories show directionally lower pay-ups as coupon cohorts increase (Exhibit 2).
Exhibit 2: The spectrum of specified pool pay-ups
“OCC” represents non-owner-occupied collateral
Source: Santander US Capital Markets, Bloomberg LP Pay-ups in 32s as of 9/6/24
Screening for pay-up convexity
Fundamental to pay-up convexity is the simplifying assumption that into a 50 bp rally the current pay-up on a specific coupon would appreciate to the pay-up for the adjacent 50 bp premium coupon, and into a 50 bp selloff the pay-up would drop to the pay-up for the adjacent 50 bp discount coupon. The potential for positive skew between these two relationships is determined to be positive pay-up convexity and the greater the magnitude of the skew, the more positively convex the pay-up on the belly coupon is.
Based on this methodology, the most meaningful pay-up convexity is localized to LLB and MLB 4.5%s where the pay-up convexity is calculated to be 23.7/32s and 17.3/32s, respectively. Loan balance cuts across the 4.0% coupon exhibit more modest but broad-based pay-up convexity, ranging from 8.7/32s to 15.5/32s between the LLB and 175k max loan balance cuts. Loan balance 3.5%s exhibit a relatively flat convexity profile across cuts, with an 8/32 skew across the 110k to 200k max cohorts (Exhibit 3). Away from loan balance, 100% New York 3.0% and 4.0% and Investor 3.0% pools offer some of the largest nominal pay-up convexities.
Exhibit 3: Pay-up Convexity Across Specified Stories
Source: Santander US Capital Markets, Bloomberg LP
Marrying OAS and pay-up convexity
Investors may be reluctant to rely solely on pay-up convexity as a governor of relative value across specified pools as there is a possibility that current relationships between coupons may not hold into a rally or sell off. Given this, investors may choose to employ a multi-dimensional framework that relies on more traditional valuation metrics, particularly the specified pool OAS pick up versus TBA with a pay-up convexity analysis.
Marrying the two concepts together shifts the value proposition away from belly coupons to premiums, particularly 6.5%s, as they offer the widest OAS pick up versus TBA and positive pay-up convexity in certain loan balance cuts as well as other specified stories. The 6.5% loan balance cuts of 150k to 200k offer between 4/32s and 5/32s of positive pay-up convexity along with a roughly 75 bp OAS pick versus the TBA cohort. The 100% Florida 6.5% offer just over 2/32s of pay-up convexity while LTV and 100% New York pools are marginally positive. In addition to the 6.5% cohort, select exposures in 5.5%s, namely LLB and Florida pools, offer positive convexity and substantial OAS relative to TBA as they pick 61 bp and 79 bp, respectively.
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