Opportunities in Fixed Rate Mortgage-Backed Securities
By David Farris
Fixed rate Agency MBS currently offer attractive spreads to treasuries for banks. Depending on a banks risk tolerance and interest rate bias, there are attractive investments at several points along the treasury yield curve. In addition, these investments have outstanding liquidity and monthly P&I cash flows which can be reinvested in new loans or higher yielding investments in the event rates continue to move higher.
There are many different fixed MBS opportunities offered in the market each day. Shown below to illustrate the spectrum of risk and returns available are four generic, new issues with final maturities of 10 years, 15 years, 20 years and 30 years.
For banks that want to remain defensive against further interest rate increases and stay shorter duration with their investments, the 10 year MBS is an attractive sector for accomplishing this. The 10yr MBS has a 3.6 WAL (weighted average life) in the base case scenario. Since this bond amortizes over a 10 year period and has a 10 year final maturity, running the bond at a maximum extreme stress scenario of a 0% prepayment speed (which is not likely to happen), only extends the WAL to 5.1 years. The other longer final maturity MBS will have slightly more WAL extension than 10yrs if prepayments slow further, but at discount dollar prices, the market is already assuming relatively slow prepayment speeds in the base case scenario for these issues.
While the 10yr MBS is a solid defensive investment against higher rates, it is still a 3.6 WAL so it will appreciate if rates go back down. Basically, this bond performs similarly to a 3.6 year Treasury note (within a +-100 bps band) but with an additional 40 bps of yield along with the added benefit of monthly principal and interest payments.
The 10yr MBS has a lower yield and spread than the 15yr but is on a cheaper part of the yield curve. This can be seen by looking at the comparable TSY rates which are 4.38% for the 10yr and 4.20% for the 15yr, a difference of 18 bps. This is why the spread on the 10yr is 33 bps lower than the 15yr while the yield is only 14 bps lower. By moving from the 10y to the 15yr, the investor is taking 2.3 years more WAL (duration) risk while only picking up 14 bps in yield for the additional risk. For this reason, we believe the 10yr currently offers better relative value than the 15yr.
The 20yr picks up 35 bps in yield and 38 bps in spread over the 15yr with only a 0.7 year extension in WAL risk. Considering this risk return trade off, the 20yr offers better relative value than the 15yr. For investors who want to extend more in duration than the 10yr sector, 20yr fixed MBS should be considered.
30yr MBS are a longer duration alternative for investors who want to extend even more with the belief that the market is approaching the top of the rate cycle. These offer 36 bps more yield over the 20yr MBS in exchange for 1.10 years more in WAL.
The shape of the treasury yield curve is signaling that the longer end may fall more in yield vs. the short end as the market prices in the Fed potentially ending its tightening cycle. The possibility of recession on the horizon is also impacting the shape of the curve. This signal can be seen in the 44 bps of inversion between the 2yr and 10yr TSY rates (4.49% vs. 4.05%). Additionally, even the 3m TSY yield has recently moved higher than the 10yr TSY yield. Despite this inversion, we believe longer duration fixed rate MBS still offer good value for banks who want to lengthen duration at this point in the rate cycle. For those who still choose to remain short, the fixed rate MBS market offers attractive investment alternatives in that area as well.
Please contact your Country Club Bank Sales Representative for further information on the securities discussed here and to find the best investments that fit your risk tolerance and interest rate bias.
This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.
•Not FDIC Insured •No Bank Guarantee •May Lose Value