By the Numbers
Using duration barbells to enhance MBS performance
This material is a Marketing Communication and does not constitute Independent Investment Research.
Owning CMO floaters outright in place of pass-throughs may improve total returns as yield curves flatten, but it could also leave investors well shy of their targeted duration. Given this, both benchmarked total return investors and asset-liability managers could look to pair those floaters with longer duration CMOs or pass-throughs, ‘barbelling’ short and longer key rate exposures to enhance yield, carry and total return relative to a portfolio of pass-throughs with the same duration.
Building the barbell
A barbelled MBS position has historically consisted of a paired CMO position, using different ratios of floaters and last-cash-flow CMOs to replicate the duration and market value of a benchmark pass-through. But with a significant amount of the pass-through market still trading at a steep discount to par, investors can expand the possibilities to consider last-cash-flow CMOs, discount TBAs or specified pools that may pair favorably with floating-rate CMOs.
The below analysis considers pairing a conventional 6.5% cap CMO floater backed by loan balance 5.5% collateral with several alternatives:
- 5.0% and 5.5% last cash flow CMOs that pay a fixed coupon
- 2.5% and 3.0% specified pools with a maximum loan size of $175,000, and
- 2.5% and 3.0% TBA pass-throughs.
Each of these fixed-rate cash flows is then paired with the floater. The balances of floater and fixed rates are then sized to create a duration and market value neutral position to UMBS 15-year 5.0% TBA pass-throughs. From there, the duration-neutral position can be compared to ascertain advantages in OAS, convexity and total return.
The below example shows the 6.5% cap strip floater paired with a 2.5%, $175,000 max specified pool (Exhibit 1).
Exhibit 1: Loading up a key rate barbell
Source: Santander US Capital Markets, Yieldbook
Gauging relative value
In the above example the paired trade outperforms the pass-through when measured by convexity, OAS and total return in most modeled scenarios. On a market value weighted basis, the floater and loan balance pass-through position offer an additional 12 bp of SOFR OAS, roughly 40 bp better convexity. The paired trade significantly outperforms the pass-through into any further flattening of the yield curve. It offers modestly better returns into a bull steepening or modest rally in rates and only materially underperforms into a bear steepening scenario.
Stacking up the various combinations of paired trades and measuring the OAS and convexity advantage shows that combining strip floaters with more convex discount loan balance pools offers the largest pickup in OAS versus the pass-through and adds more positive convexity than other exposures. Despite the structural convexity offered by the locked-out nature of the CMO classes, the discount loan balance pass-throughs offer markedly better convexity (Exhibit 2).
Exhibit 2: Stacking up OAS and convexity advantage
Source: Santander US Capital Markets, Yieldbook
When stacking up the paired trades by total return, the floater paired with either CMO will offer modestly better base case total return given the carry advantage that the CMOs hold over both the specified pools and TBAs. Investors seeking the highest total return into a further flattening of the yield curve should pair floaters with deeply discounted TBA. Into a bull flattening of the yield curve, the more negatively convex TBA will prepay and pull to par faster than loan balance cuts, and the deeper the discount, the greater the return generated by dollars being returned at par through prepayment. The deeply discounted TBAs will also outperform into a bear flattening of the yield curve as they are not susceptible to declines in elevated specified pool pay ups against the backdrop of higher rates (Exhibit 3).
Exhibit 3: Stacking up total return
Source: Santander US Capital Markets, Yieldbook
The barbell strategy is not without risk; it leaves investors acutely susceptible to a bear steepening of the yield curve although that can be mitigated to some degree by going up in convexity in the loan balance specified pools that should offer extension protection in the face of rising longer key rates. And any of these positions should leave the investor holding more spread duration than the pass-through, leaving them vulnerable to potential widening in the MBS basis. With that said, the market is still leaning towards a hike in short rates by the end of this year and somewhat mixed economic data could keep the long end of the curve rangebound. Given the bias towards a flatter curve, it begs the question “Do you even lift bro?”
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