By the Numbers
Relative value favors up-in-coupon TBAs and 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.
Bouts of elevated interest rate and equity volatility in April have left MBS across the coupon stack wider in both TBA and specified pools. The restriking of valuations warrants a fresh look at relative value. Hedge-adjusted returns and carry suggest MBS investors should skew exposure to higher coupons, specifically 6.0%s and 6.5%s in conventional TBA. Specified pool buyers should consider specific geography stories, particularly 100% Texas 5.5%s and 100% Florida 6.0%s.
Higher coupon MBS look attractive despite modestly outperforming the rest of the coupon stack most of April. Higher coupons may continue to outperform as net outflows, rotations out of MBS into other fixed income exposures, or both may disproportionally impact lower coupon MBS. Managers looking to remain close to home on their index weightings in the face of MBS outflows should trim any overallocation to lower coupon MBS,
Duration-hedged total return favors conventional 6.0% and 6.5% TBA
Hedging the duration of each coupon in the stack with a market value neutral combination of 2-year and 10-year Treasuries shows that TBA 6.0%s offer the highest base case projected 1-year total return at 2.18%. The 5.5% and 6.5% cohorts offer comparable, attractive base case total return as well at 1.92% and 1.94% respectively. Of these cohorts, 6.5%s offer the flattest profile across curve shocks. Absent any hedge rebalancing, total return falls by just 25% into a 100 bp rally and 50% in a 100 bp sell off. By comparison, returns on 5.5% and 6.0% fall by upwards of 40% into a rally and more than 60% into a sell off (Exhibit 1).
Exhibit 1: Duration-hedged total returns across the stack
Note: All market levels as of April 30, 2025. Analysis assumes linear parallel moves in the yield curve to the 1-year horizon, reinvestment at 1-month SOFR and repricing at constant OAS.
Source: Santander US Capital Markets, Yieldbook
6.5% offer positive hedge-adjusted carry as well
A look at hedge-adjusted carry skews relative value up-in-coupon as well. This approach compares 1-month returns on each coupon against a hedge with matched duration and convexity using 2- and 10-year Treasury debt along with 1-month 10-year at-the-money swaption straddles. FNCL 6.5%s are the only coupon in the stack currently offering positive hedge-adjusted carry. Hedge-adjusted carry on 6.5%s is only modestly positive, offering slightly more than 1/32 of net carry. Conversely, coupons in the belly of the coupon stack have the highest negative carry. TBA 4.0%s are the worst performing coupon at 2.5/32s of negative carry (Exhibit 2).
Exhibit 2: 6.5% positive carry with belly coupons the worst performers
Source: Santander US Capital Markets, Yieldbook
Texas and Florida offer the best relative value in higher coupon specified pools
Certain higher coupon specified pool stories look to offer attractive relative value as well. The notable caveat being that higher coupon specified stories may be more difficult to scale as much of the float in certain stories may already be locked up in CMOs as dealers have found arbitrage opportunities in specified stories. In lower pay-up stories, loosely defined as no greater than 8/32 above TBA, 100% Texas 5.5% offer a similar prepayment S-curve to other higher pay-up stories. 100% Texas 5.5%s, at a pay-up of roughly 7/32s over TBA, offer 40 bp of OAS. They exhibit a similar S-curve to higher pay-up stories such as 100% Florida, low FICO and investor pools that trade to pay-ups of 28/32, 21/32 and 15/32s respectively (Exhibit 3).
Exhibit 3: Prepayment S-curves across low and moderate pay-up specified stories
Source: Santander US Capital Markets
100% Florida 6.0% pools look to offer attractive relative value when compared to loan balance and other higher pay-up stories as they offer wider OAS with less pay-up risk. At a pay-up of just over one point, these pools offer approximately 56 bp of OAS, an 8 bp pick to TBA. Comparing these to 150k or 175k max loan balance pools shows that 150k max pools, at a pay-up of $1-20/32s offer just 46 bp of OAS, 10 bp tighter than the Florida pools and through TBA. These pools also compare favorably to 175k max loan balance pools which trade to a pay-up of $1-15/32s and a 45 OAS, an 11 bp concession to Florida pools.
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