By the Numbers
Shift in discount MBS from conventional to Ginnie Mae
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.
It looks like a good time to shift discount MBS exposure from conventional to Ginnie Mae. Conventional MBS have outperformed credit since the end of June but have also left Ginnie Mae MBS behind. Ginnie Mae option-adjusted spreads in many coupons now trade wider than the 80th percentile of the 5-year range, and in most coupons Yield Book projects Ginnie Mae total returns will top conventionals’ over the next year. In premiums, investors are rightly concerned about fast Ginnie Mae prepayments, but spreads may tighten after the worst prepayment prints are in the rearview mirror. And in discounts, FHA and VA collateral generally offer better extension protection than conventional loans.
Ginnie Mae coupons below 4% all have widened relative to conventional MBS since the end of June (Exhibit 1). This shows the OAS for each conventional and Ginnie Mae coupon as the percentile rank compared to the prior five years of history. The conventional OAS in each of those coupons tightened over that time; for example, the FNCL 2.5% OAS was trading at the 79th percentile at the end of June and tightened to the 59th percentile as of September 18. But the Ginnie Mae 2.5% coupon widened from the 74th percentile to the 79th percentile over that time. Ginnie Mae 3%s through 4%s did tighten, but not as much as conventionals.
Exhibit 1. Discount Ginnie Mae OAS widened relative to conventional since June.
Source: Bloomberg, Santander US Capital Markets.
Many Ginnie Mae premium coupons jumped sharply wider (Exhibit 2). The 5.5% through 6.5% OASs were all at roughly the 20th percentile or tighter but have widened out to roughly the 80th percentile or wider. That’s a huge move, especially considering those conventional coupons tightened. The difference was not as pronounced in 5%s and there was very little difference in the 4.5%s.
Exhibit 2. Premium Ginnie Mae OASs widened sharply in 5.5%s and above.
Source: Bloomberg, Santander US Capital Markets.
Lower mortgage rates have rightly raised concerns about Ginnie Mae prepayment speeds. Loans guaranteed by the US Department of Veterans Affairs typically refinance very quickly, but they do exhibit some burnout after the initial surge in speeds (they stay fast, just not as fast). United Wholesale Mortgage introduced a program—Govy125—that gave loan officers incentives to refinance government loans, but the program stopped accepting loan applications in early September. Its replacement program, Refi75, offers a lower incentive and is also available for conventional loans. So UWM should have a smaller effect on the Ginnie-to-Fannie speed differential over the next few months.
The wider spreads for discount Ginnie Mae MBS are reflected in higher projected total returns over the next year for many coupons (Exhibit 3). The three coupons that underperformed conventionals the most since June—2.5%s, 3.0%s, and 3.5%s—each have higher projected returns in rate moves of up to 100 bp in either direction. None of these conventional rolls are currently special, but the G2SF 3.5%s and 4.0%s are about 0.5/32s special, so that would provide an added lift over the total returns shown in the chart.
Exhibit 3. Ginnie Mae projected 1-year total returns outpace FNCL in 2.5%s–3.5%s.
Projected returns do not consider special financing from dollar rolls.
Source: Yield Book, Santander US Capital Markets.
Premium Ginnie Mae MBS are also projected to have higher total returns than conventional mortgage-backed securities (Exhibit 4). Returns on the 4.5% and 5% coupons are relatively close, which makes sense since those coupons have similar option-adjusted spread rankings. But projected returns for Ginnie Mae in the 5.5% through 6.5% coupons exceed conventional in all rate scenarios except for the 5.5%s in a 100 bp rally. The 6.0% and 6.5% Ginnie Mae rolls are also trading special, at 2.27/32s for the 6%s and 3.52/32s for the 6.5%s. So Yield Book’s model thinks that spreads are wide enough to compensate for the added negative convexity of Ginnie Mae MBS.
Exhibit 4. Ginnie Mae 1-year total returns are projected to beat FNCL in 5.0%s–6.5%s.
Projected returns do not consider special financing from dollar rolls. Source: Yield Book, Santander US Capital Markets.
Currently dollar rolls for many G2SF coupons are offering special financing, while most conventional coupons are not (Exhibit 5). In Ginnies, the 3.5%s through 5.0%s, 6.0%s and 6.5%s are all special. Only the conventional 6.5% roll is special, but only 0.76/32s compared to 2.52/32s for the Ginnie Mae.
Exhibit 5. G2SF rolls are special in most coupons.
Source: Yield Book, Santander US Capital Markets.
The spreads and returns suggest now may be a good time to allocate into Ginnie Mae and away from conventional. In discounts Ginnie collateral usually prepays faster than conventional, and FHA borrowers in those coupons are likely to be more responsive to lower rates and an increase in housing affordability. In premiums like 6%s and 6.5%s, it could be spreads have widened to account for the faster Ginnie speeds in a refinance environment, so are poised to tighten as speeds in those coupons ultimately slow due to burnout. But in the belly of the stack, like 4.5%s, it should be better to stick with conventionals. Ginnie Mae MBS offer little return advantage and could jump wider if interest rates rally further.
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