By the Numbers
A tactical short in the basis
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 note was originally distributed on August 3, 2022.
Nominal and option-adjusted spreads on MBS have tightened significantly through June and July, raising the possibility of picking up total return by tactically shorting MBS against Treasury debt. The best spot for doing that looks like FNCL 2.0%s where an estimated only 7 bp of spread widening put the trade in the money.
A portfolio can match market value and duration in FNCL 2%s with a combination of 10-year Treasury debt and cash (Exhibit 1). The MBS position has a natural yield advantage to compensate for negative convexity. The MBS carry advantage shows up in most of the total return scenarios where getting long Treasury debt against MBS underperforms. The MBS advantage diminishes over larger rate moves as the convexity of the Treasury position kicks in. The Treasury position importantly avoids the 7.80 spread duration of the MBS.
Exhibit 1. Replacing FNCL 2%s with the 10-year Treasury bond
Note: All market levels as of 8/2/2022 close. Returns assume a linear shift over the holding period, reinvestment in 1-month T-bills and repricing at constant OAS.
Source: Yield Book, Amherst Pierpont Securities
Spreads only must widen 7.3 bp to break-even in the base case 1-year total return. The break-even spread widening is estimated by dividing the MBS’s performance advantage by the spread duration [7.3 bp=100.0*(0.57/7.80)]. It would take 7.8 bp widening to break even in the lowest scenario, a 25 bp rally.
The nominal mortgage basis—the spread of the par coupon to the interpolated 7.5-year Treasury curve—is currently 128 bp but was roughly 140 bp to 145 bp for much of June and July. It peaked at 151 bp on July 14. The basis widened 14 bp yesterday, undoing a lot of the tightening that followed the FOMC meeting last week, so mortgage spreads are volatile. It is plausible that the basis could widen another 12 bp or more to get back to the typical level in June and July.
An investor with a curve view could replace the MBS with a combination of 5-year and 10-year treasuries instead of cash and 10-year treasuries (Exhibit 2). The 10-year+5-year combination is better than the 10-year+cash combination when the curve steepens but worse when it flattens. Otherwise, the yield, convexity, and parallel-shift total returns are comparable to the 10-year+cash combination.
Exhibit 2. Replacing FNCL 2%s with 5-year and 10-year Treasury bonds
Note: All market levels as of 8/2/2022 close. Returns assume a linear shift over the holding period, reinvestment in 1-month T-bills and repricing at constant OAS.
Source: Yield Book, Amherst Pierpont Securities
This trade can also be done in higher coupons, but more spread widening is needed to break even on the trade. The total returns are lower because higher coupon MBS carry better than lower coupon MBS, and spread durations are shorter. For example, the 1-year total return in the base case drops 0.91% when replacing FNCL 3%s with Treasuries, and the spread duration falls to 7.02. That trade needs 13 bp of widening to break even.
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