By the Numbers
Dodging spread widening in 15-year 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.
MBS spreads are likely to keep widening this year as the Fed scales back its MBS purchases. The Fed plans to stop growing its MBS portfolio by mid-March and allow it to shrink later this year. In recent months the Fed’s purchases of 15-year MBS have exceeded the net new supply, keeping spreads tight and the sector rich to 30-year MBS. Spreads may widen quickly as the Fed’s buying slows and effective net supply turns positive. The shorter duration of 15-year MBS helps protect investors against spread widening but there are opportunities to further reduce spread exposure. Buying hybrid ARMs, 20-year pools, or moving up-in-coupon each protects against spread widening with differing trade-offs.
Buying hybrid ARM pools instead of 15-year MBS should offer significant protection from spread widening. The Fed is not buying hybrid ARMs, so spreads may widen less than fixed rate MBS as the Fed slows its MBS purchases. Hybrid ARMs also have shorter durations than 15-year MBS, reducing exposure to any widening that does hit the sector. For example, a duration- and proceeds-neutral combination of a 6 WALA 7/6 SOFR hybrid ARM and 10-year Treasury debt shortens spread duration by 1.45 years, 32% less than FNCI 2%s (Exhibit 1). A SOFR 7/6 hybrid is fixed-rate for seven years, after which it resets twice a year to a margin over SOFR subject to some rate caps. The hybrid ARM position also adds convexity, which helps in larger rate moves. However, its yield, OAS, and 1-year total returns are slightly lower than the 15-year MBS, so it could underperform a bit if no spread widening materializes.
Exhibit 1. SOFR hybrid ARMs protect against spread widening
As of 2/2/2022.
Source: Yield Book, Amherst Pierpont Securities
Another alternative is to buy 20-year MBS instead of 15-year MBS (Exhibit 2). The combination of 20-year MBS and Treasury debt has a lower spread duration than the 15-year MBS, although the improvement is less than for the hybrid ARM trade. The 20-year position also offers better yield and OAS, and the total returns are generally better. However, the 20-year trade has lower convexity and underperforms in large rate moves. The Fed has bought few 20-year pools since they typically trade at a pay-up to 30-year MBS, although can be delivered into the 30-year TBA. Spreads for 20-year MBS consequently may not widen together with 30-year spreads.
Exhibit 2. 20-year MBS offer better yield, spread duration, and total returns
As of 2/2/2022.
Source: Yield Book, Amherst Pierpont Securities
Another way to protect against wider spreads is to shift up-in-coupon. Higher coupon MBS have less exposure to spread widening than lower coupon MBS (Exhibit 3). Buying a combination of FNCI 2.5% and 10-year Treasuries instead of FNCI 2%s lowers spread duration by 1.76 years, a nearly 40% reduction. The combination also offers higher OAS and better convexity. However, the FNCI 2% has a higher yield and, unless interest rates move more than 50 basis points, better total returns. Therefore, the investor bears some risk of underperformance if rates don’t move a lot and spreads don’t widen as anticipated. The second table shows that spread duration does not drop as much from a move to the 3% coupon.
Exhibit 3. Move up-in-coupon to FNCI 2.5%s to lower spread duration
As of 2/2/2022.
Source: Yield Book, Amherst Pierpont Securities
Moving up-in-coupon from 2.0%s to 2.5%s has a similar profile to the hybrid ARM trade. Spread duration shortens a bit more moving up-in-coupon, but hybrid ARM spreads may not widen as much as 15-years spreads since the Fed has not been buying hybrids. The hybrid ARM trade tends to have better 1-year total returns than moving to FNCI 2.5%s, although the better convexity of the latter kicks in if rates move a lot. Staying in 15-year MBS does allow investors access to the dollar roll. But not all investors can roll their positions and roll specialness may fade when the Fed stops growing its MBS portfolio in March.
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