Pub. 5 2016 Issue 8

l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s 30 Figure 1 - Fannie Mae 15-year 4%Moderately Seasoned Speeds The prepay benefits of this 4% Mega pool come with a price in the form of a 109-5+ premium. At this level, with a projected 12 CPR, the bond yields 1.60% and 61bps of spread to a duration equivalent Treasury. You might be saying to yourself, surely there are cheaper bonds out there, and you’d be right! For example, a recently issued FNMA 15-year 2.5 has been trading at a much lower premium of 103-22 (FNMAAL8777). This has a slightly lower spread of 53bps, but an even better yield of 1.68%, assuming a 10 CPR. To the uninitiated, this information alone would suggest you should buy the newer issue 15-year for more yield. So the question is this: What is the premium on the higher coupon Mega giving me, considering I’m sacrificing 8bps of yield? Figure 2 shows price shocks in 100bp increments as well as the swing in the bond’s average lives for these two examples. In the more extreme example of rates up 300bps, the 110K 4% Mega has price depreciation of -10.9% compared to -14.5% for the new issue pool. The 110K 4% Mega also has far less extension risk with a 4.78-year average life as rates are shocked up 300bps compared to 6.23 years for the 2.5% 15-year. Clearly, the 4% PREPAY PROTECTION - THERE’S NO FREE LUNCH P REPAYMENTS FROM September increased the most since the 2012 Refi Wave, the result of near lows in mortgage rates and a few more days in the day count for mortgage applications to close. As is typically the case as prepayments rise, demand for prepayment protection is on the rise. Investors in specified pools know all too well the benefits of low loan balance collateral as a form of prepayment and extension protection, but many are finding it difficult to stomach the relative “pay-ups” associated with these pools in today’s market. As always, it boils down to a simple discussion of risk vs. reward. Portfolio managers should avoid viewing any attribute of an MBS pool in isolation. For example, it’s no secret that higher coupon pools (compared to their lower coupon counterparts) offer far less price volatility in a rising rate environment. However, we would be remiss if we simply focused our product selection on high coupon pools alone. When rates fall, higher coupon pools will have a larger incentive to refinance; therefore, investors should also seek out prepayment protection attributes to mitigate these risks. High coupon pools coupled with loans that have low loan balances, high investor/vacation mortgage loans, or HARP collateral have proven to provide the best forms of prepay protection. Figure 1 below is a comparison of speeds in the universe of Fannie Mae 15-year 4s with moderate seasoning (30-60 WALA). We’ve compared this cohort’s speeds (orange line) to FNMAAL6043, a 15-year Mega 4% specified pool (blue line) with 31 months of seasoning. The loans in the FNMA 15- year Mega have a max loan size of $110K, 43% of which are investor or vacation mortgages. Since the pool was originated in November, it has paid at an average 9.5 CPR. During this same time, its cohort has averaged about 4 CPR faster at 13.3 CPR.