By the Numbers
Relative value skews towards prime jumbo in longer 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.
The recent rise in rates and steepening of the yield curve has provided investors with an attractive entry point to add longer, locked out MBS cash flows. Relative value across most points on the yield curve generally skews towards agency over non-agency exposures, but longer MBS appears to be one notable exception. Last cash flows backed by prime jumbo collateral offer attractive relative value. Pairing higher coupon last cash flows with deeper discount bonds offers an attractive combination of current carry with a stable return profile into a rally or further sell off.
Since the beginning of December 10-year Treasury yields have sold off by 30 bp and the spread between two and ten-year yields has widened by roughly the same amount (Exhibit 1). Higher rates and a steeper curve have created an attractive entry point for investors to increase exposure to longer duration, locked out exposures that will generate total return as they roll down a steeper curve.
Exhibit 1: A steeper curve creates an attractive entry point for long duration MBS
Source: Santander US Capital Markets, Bloomberg LP
Relative value across the last cash flow coupon stack
Investors looking to add duration through MBS can look to discount pass-throughs or structured MBS. The non-agency market offers a fairly robust primary and secondary market in longer duration, last cash flow sequentials backed by prime jumbo loans where investors can access current coupon exposure at wider spreads in the primary market and deeper discount seasoned bonds in the secondary market, admittedly at tighter nominal spreads. Not dissimilar to the agency market, the fast and precipitous rise in rates over the course of 2022 limited the float in ‘belly’ coupons with more significant outstanding exposure in 2.5% to 3.5% coupons and 5.5%s and above. Across exposures, 3.5% coupon last cash flow sequentials offer the widest OAS with fairly low option cost. In current coupon options, 6.0% coupons offer more OAS than 5.5%s despite higher option cost (Exhibit 2).
Exhibit 2: OAS and option cost across the prime LCF coupon stack
Source: Santander US Capital Markets, Bloomberg LP, YieldBook
Note: All bonds are 25% last cash flow options at issuance across 2022 to 2024 vintage transactions
The universe of coupon options is further evaluated based on hedge-adjusted total return. Each exposure is Treasury hedged using either 5- and 10-year Treasuries for higher coupon options or a combination of 10-year and long bond hedges for deeper discount options. Consistent with the higher observed option cost, 6.0% last cash flows offer significantly greater total return at-the-money than other exposures with the steepest downturn in performance given a shift away from current rates. In discount options, 3.5%s stand out as offering both elevated at-the-money total return and a stable, hedge-adjusted return profile across modeled scenarios (Exhibit 3).
Exhibit 3: Hedge-adjusted returns across prime last-cash flows
Source: Santander US Capital Markets, YieldBook
Based on these return profiles, investors should look to pair 3.5% profiles with 6.0% as blended exposure offers an attractive combination of base case total return and upside to lower rates as the 3.5%s will hold their duration better into a sustained rally (Exhibit 4). Additionally, investors who maintain a more bullish view or rates could further enhance returns by pairing back hedge ratios to less than the fully hedged analysis presented here.
Exhibit 4: Pair 3.5% and 6.0% last cash flows for enhanced returns across scenarios
Source: Santander US Capital Markets, YieldBook
Note: Analysis assumes a 60%/40% blend of 3.5% and 6.0% coupon LCF
Comparing relative value versus agency LCF
Unlike non-agencies, there is a less robust secondary market in discount last cash flow bonds, primarily due to that buyers of long duration CMOs tend to be more ‘buy and hold’ portfolios like domestic and foreign insurance companies and to some degree domestic depositories. Given this, an analysis of relative value across agency and non-agency last cash flow bonds should be centered around current coupon, new issue offerings. Normalizing across 5.5% last cash flow options in prime jumbo versus CMOs backed by conventional collateral suggests prime jumbo last cash flows offer an additional 30 bp to 40 bp of nominal spread with new issue prime jumbo bonds trading in the context of 140 to 150 bps over Treasuries with CMOs trading at spreads of roughly 110 bp. Additionally, despite significantly lower loan sizes, agency last cash flow CMOs carry comparable option cost to jumbo last cash flow bonds. And when measured by hedge adjusted total return, jumbo last cash flows substantially outperform agency CMOs in most modeled scenarios with the notable exception of a pronounced rally in rates, skewing relative value in favor of private label exposures (Exhibit 5).
Exhibit 5: RV favors prime jumbo over last cash flow CMOs
Source: Santander US Capital, YieldBook
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 © 2025 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.
