By the Numbers
Investor pools offer attractive relative value in prime pass-throughs
This material is a Marketing Communication and does not constitute Independent Investment Research.
Investors who can sell liquidity in the private MBS market can pick up substantial relative value in pass-throughs backed by both agency-eligible investor loans and owner-occupied loans with conforming balances. The convexity of these loans looks mispriced as those pass-throughs trade at comparable spreads to more negatively convex non-conforming jumbo pass-throughs. Private pass-throughs backed by agency-eligible investor loans continue to trade to appreciable discounts to agency TBA while similar loans fetch a meaningful pay-up when pooled in agency MBS.
Measuring convexity in prime private MBS collateral
Cutting the universe of prime private MBS collateral by loan size shows that conforming balance loans securitized in private trusts prepay significantly slower than both jumbo conforming and non-conforming loans. Given 100 bp of refinancing incentive, for example, conforming balance collateral has prepaid at roughly 27 CPR, while both jumbo conforming and non-conforming loans prepaid at nearly 50 CPR (Exhibit 1).
Exhibit 1: Conforming balance loans have a much flatter S-curve than private label jumbo
Source: Santander US Capital Markets, CoreLogic LP
Similarly, when cutting the universe of prime private MBS loans by occupancy, investor loans prepay substantially slower in-the-money than both owner-occupied loans and loans financing second homes. Given 100 bp of incentive, investor loans in private trusts prepay at just 27 CPR, roughly half the rate at which owner-occupied loans prepay give the same amount of incentive (Exhibit 2). Admittedly, agency-eligible investor loans do prepay slowly when out of the money, and as a result, bond investors may look to more seasoned collateral to help mitigate extension risk into higher rates.
Exhibit 2: Investor loans prepay slower in-the-money
Source: Santander US Capital Markets, CoreLogic LP
Framing relative value
Focusing on the 5.5% cohort, both jumbo and conforming pass-throughs trade at a roughly 30/32 concession to agency TBA while 5.5% private investor pass-throughs trade roughly 12/32s tighter than jumbo or conforming bonds, at a 18/32 concession to TBA. In contrast, the 5.5% agency investor specified pool traded at 24/32 pay-up over TBA in Fannie Mae’s March cash window auction. The $1-10/32 difference in price between the 5.5% agency investor specified pool and the private investor pass-through translates to 45 bp more OAS on the pass-through relative to the specified pool, at 59 bp and 14 bp respectively. The investor pass-through also maintains a lower option cost despite being more structurally levered due to the private MBS shifting interest structure (Exhibit 3).
Exhibit 3: Investor pass-throughs deliver substantially more OAS than specified pools
Source: Santander US Capital Markets, YieldBook
At nearly a one point price concession to TBA, private 5.5% conforming balance pass-throughs offer a 23 bp OAS advantage versus TBA, potentially making them an attractive out-of-index means by which benchmarked money managers can add excess return. Average loan balances on investor pass-throughs tend to be marginally higher than assumptions for the TBA deliverable and tend to be backed by stronger borrowers with high FICO scores and low SATO on the loans. Despite being backed by higher balances and borrowers with limited friction to refinancing, option cost on investor pass-throughs is roughly in-line with that of TBA.
Investor pass-throughs deliver attractive total return
On a hedged basis, private 5.5% investor pass-throughs deliver substantially better and more stable total returns than TBA, specified pools or other private MBS exposures. Hedging all five exposures with a combination of 2- and 5-year notes, private 5.5% investor pass-throughs offer a base case, hedge-adjusted return of 1.54% and positive hedged total returns into both a 100 bp rally and sell off, assuming no rebalancing of the hedge (Exhibit 4).
Exhibit 4: Stacking up total pass-through total returns
Source: Santander US Capital Markets, YieldBook
Private 5.5% investor pass-throughs deliver 32 bp of hedged total return into a 100 bp rally and 53 bp of hedged return into a 100 bp selloff despite investor collateral having a propensity to pay slowly out-of-the-money. That translates to over a 1% total return advantage relative to TBA into a rally and a 58 bp advantage versus TBA into a selloff. When comparing the investor pass-through versus the specified pool, the pass-through offers an incremental 11 bp of base case hedged total return, a 97 bp advantage versus the pool into a 100 bp rally and a 54 bp advantage into a sell off.
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