By the Numbers
Going up-in-coupon in MBS for excess return
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.
Agency MBS with higher coupons continue to offer the greatest projected 1-year total returns across the coupon stack. And with volatility at its lowest level since March 2022, according to the MOVE index, most coupons are positive carry after hedging duration and convexity. And carry after hedging convexity is greatest for higher coupons, suggesting investors are adequately compensated for the added prepayment risk. FNCL 6%s have the highest projected excess returns and hedge-adjusted carry according to Yield Book’s latest experimental model. Investors can earn additional carry in that coupon with high LTV or 100% Texas specified pools.
Every FNCL coupon is projected to have positive excess returns after hedging duration using Treasuries (Exhibit 1). Excess returns are generally greater for higher coupons to compensate for worse convexity. Base case returns are high enough that returns stay positive if rates increase or decrease up to 100 bp. And even in those large rate moves the 6%s are either the highest or second-best coupon, falling behind 6.5%s in the extreme rate scenarios.
Exhibit 1. FNCL 6%s have the highest projected excess returns in most rate scenarios.
As of 12/11/2024. Each line shows the projected one-year total return of a TBA in excess of a portfolio of 2-year and 10-year UST that has the same market value and duration.
Source: Yield Book, Santander US Capital Markets.
Projected one-month carry is also positive after hedging for convexity using 1M10Y swaptions (Exhibit 2). It is positive for all coupons in rate moves of up to 50 bp in either direction and is even positive in the base case for most coupons. That means the MBS excess return is more than large enough to pay for the convexity hedge; often investors need to accept negative carry if rates don’t move. The highest projected carry is from the 6% and 6.5% coupons.
Exhibit 2. FNCL 6%s and 6.5%s have the highest projected one-month carry after hedging duration and convexity.
As of 12/11/2024. Each line shows the projected one-month carry of a combination of TBA and 1Mx10Y swaption in excess of a portfolio of 2-year and 10-year UST that has the same market value, duration and convexity.
Source: Yield Book, Santander US Capital Markets.
The portfolio of FNCL 6%s hedged with 2- and 10-year Treasury notes and a 1M10Y at-the-money swaption straddle is positive yield and OAS (Exhibit 3). The swaption straddle’s lowest carry comes in the base case, since the investor has paid the premium but the options expire at-the-money. However, the return of the TBA is greater than the option premium, so the trade is positive carry if rates don’t move, and is positive carry from -50 bp to +50 bp.
Exhibit 3. Hedging duration and convexity of FNCL 6% with UST and 1Mx10Y swaptions.
As of 12/11/2024.
Source: Yield Book, Santander US Capital Markets.
There are several specified pool options available in the 6% coupon that can add additional carry over TBA and reduce negative convexity for investors that do not hedge with swaptions (Exhibit 4). Dollar rolls are currently not special in any conventional coupon, so a specified pool buyer is not losing return by moving out of TBA. The left-hand side of the table shows projected carry in excess of TBA using Yield Book’s v97 experimental model and is sorted from shortest to longest breakeven period. The top options are high LTV cohorts and 2022 and 2024 worst-to-deliver (non-specified) collateral. The top cohort is high LTV from 2024, which is projected to add 0.464/32s above TBA carry next month, and breakeven on the 8.6/32s pay-up in 18.6 months.
Exhibit 4. Several FNCL 6% specified pools offer better carry than TBA.
As of 12/11/2024. TBA carry from Yield Book.
Source: Yield Book, Santander US Capital Markets.
The right-side of the table shows the same calculations using the November print, which is generally faster than the projected speeds for December in this coupon. Six of the cohorts are still positive carry to TBA even when run at the higher November speed.
There are specified pool options in 6.5%s that offer better carry than TBA, but many are very high pay-ups and have extremely long breakeven periods (Exhibit 5). The best options are high LTV pools from 2024 and 2023, followed by the 2024 Max $275,000 cohort. At the other extreme, the pay-up for NY 6.5%s is so high that the breakeven period exceeds the maturity of the pools.
Exhibit 5. Several FNCL 6.5% specified pools offer better carry than TBA.
As of 12/11/2024. TBA carry from Yield Book.
Source: Yield Book, Santander US Capital Markets.
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