By the Numbers
Looking for protection from wider MBS spreads
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.
MBS spreads have widened since the beginning of January, a trend likely to continue this year. The Federal Reserve will no longer be growing its MBS portfolio after mid-March and is widely expected to allow the portfolio to shrink sometime this year. Bank demand is also likely to fall. But net MBS supply could easily reach $90 billion a month due to rapid home sales and Fed runoff. Heavy supply and light demand are a recipe for wider spreads, which will be needed to entice money managers and other investors to increase allocations to MBS. One way to protect against spread widening is to shift MBS exposure to higher coupons with less spread duration.
The Bloomberg MBS index shows that higher coupons have posted higher excess returns than lower coupons so far this year (Exhibit 1). These returns do not account for any gains from special dollar rolls. Conventional and Ginnie Mae 30-year coupons of 3.0% or lower have negative excess returns, while 3.5% and higher coupons have positive. In 15-year pass-through, the 2.5% and lower coupons show negative excess while the 3.0% and higher coupons show positive. MBS spreads are wider over that time. For example, the spread between the MBS current coupon and a 50% average of the 5-year and 10-year Treasury bonds has increased 17 bp since January 3. Spread duration is higher for lower coupons, so those coupons were hit the hardest by higher spreads.
Exhibit 1. Month-to-date MBS excess returns
As of 1/26/2022.
Source: Bloomberg MBS Indices, Yield Book, Amherst Pierpont Securities
Shifting MBS exposure into higher coupons helps limit the exposure to wider spreads. And wider spreads are a concern given falling Fed and bank demand alongside heavy net supply. Fed research has shown that the size of the Fed’s MBS portfolio has a significant effect on the MBS basis, which means spreads are likely to leak wider as the Fed allows the MBS portfolio to shrink. Of course, the market has likely anticipated wider spreads, and weaker demand has created the widening much faster.
Moving up-in-coupon shortens MBS portfolio duration, but this can be offset by adding duration in Treasuries (Exhibit 2). The table compares a long position in FNCL 3%s and the 10-year Treasury note to a duration- and proceeds-neutral short position in FNCL 2%s. The MBS and Treasury combination picks 22 bp extra OAS and has more positive convexity than the FNCL 2%, although static yields are slightly lower. The negative spread duration means that the MBS and Treasury combination should outperform the FNCL 2% if spreads widen.
Exhibit 2. Moving up in coupon lowers spread duration and increases convexity
Source: Yield Book, Amherst Pierpont Securities
The 1-year total returns show that the FNCL 2% performs slightly better for smaller interest rate moves if spreads do not widen (Exhibit 3). The combination of FNCL 3% and 10-year Treasury does better for larger moves that benefit from more positive convexity.
Exhibit 3. Total returns for an up-in-coupon trade
Source: Yield Book, Amherst Pierpont Securities
This idea should work similarly for other coupons. The higher coupon and Treasury combination will outperform the lower coupon if MBS spreads widen or if there are larger interest rate moves. Instead of Treasuries, investors can add duration using corporates or, if the portfolio allows it, futures.
Another consideration are dollar rolls, for investors that can roll TBA. The lower coupon is rolling special for now, but investors can also take advantage of special financing in 3%s and 3.5%s. If the investor sells the lower coupon to buy a higher coupon and Treasury debt, the lower outright MBS exposure means less exposure to special financing. But if the investor sells the lower coupon, buys the higher coupon and extends duration in an existing Treasury allocation, full exposure to special financing continues. Or if the investors sells the lower coupon, buys the higher coupon and rebalances duration with futures, full exposure to special financing also continues.
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