Agency bullets look attractive to agency MBS while agency callable levels are still rich to agency MBS, point out Citi analysts, after considering the recent extension in mortgages.

Rohit Thapliyal and team at Citi Research note the nominal un-hedged carry to be marginally higher than MBS than on callables

Recent extension in mortgages

The Citi analysts note in their report that mortgages have extended quite a bit over the past year with the 30-year 3.5% TBA currently priced around par with an effective duration of over 7 years and a WAL of 8.5 years. The analysts point out that the 10-year Freddie Mac bullet issued a couple of years ago is the closest in terms of duration and WAL to the 3.5% MBS.

While in the past, the analysts would typically compare 30-year mortgages with 5-year agency bullets, 5-year agencies were usually pretty close to the WAL of a par-priced mortgage and thus were viewed as good substitutes. However, thanks to the recent extension witnessed in mortgages, the analysts modified their comparison to use agency bullets with a more similar WAS to that of the MBS to form their observations.

Agency bullets look attractive

To assess relative value, the Citi analysts compared mortgages with agency bullets. Considering mortgages’ recent extension, the analysts use a longer bullets for their analysis, instead their typical 5-year agency bullet comp.

To properly compare the two asset classes, the analysts looked at the option-adjusted spread of the two assets. The analysts note on an OAS basis, after providing for optionality, agency bullets are actually cheap to mortgages, with the spread at the 70th percentile over a 1-year history. This can be evidenced from the following graph:

MBS-Agency bullet-OAS to swaps mortgages

The Citi analysts note the nominal yield on the par-priced 30-year 3.5% MBS is about 50 bp higher than on a similar WAL 10-year agency bullet. As can be deduced from the following graph, the 50bp yield difference is actually very tight, indicating agencies are cheap, at the 77th percentile over one-year history.

MBS-Agency Bullet-Yield comparisons

Agency callable levels look rich

Turning their focus to agency callables instead of agency bullets, the analysts observe agency callables like agency MBS have negative convexity and hence are a better comparison to mortgages, when looking at nominal yields and projected performance in different rate scenarios.

The following graph captures projected yields versus effective duration of mortgages, agency debt and US Treasury bonds. The Citi analysts note yields of the agency callables are generally higher than the yields of the like-duration mortgages.

Projected yield Vs effective duration

The analysts point out that such a difference in yield is primarily due to the fact that callables currently have higher negative convexities than mortgages. As can be deduced from the following table, the analysts point out there is one callable that has almost the same effective duration and the same negative convexity as the 30-year 3.5% MBS mortgage – the 10NC3Y callable. However, this bond yields almost 21 bp lower than the mortgage.

FN 3.5 pc VS 10NC3Y Berm

Hence, the analysts conclude that agency callables are still rich to mortgages.