How To Look Under The Hood When Investing In Mortgage-Backed Securities (part 2)

Many MBS pools look alike on the surface but digging deeper can reveal major differences. Part 2 looks at how the Conditional Prepayment Rate can affect yield.

 
 

Last week we looked at two MBS pools that looked similar on the surface but once we “looked underneath the hood” we found distinct differences. Here is the link to the previous article as a refresher.

Let’s review the two securities:

POOL # Coupon Issue Date Maturity Date PRICE Yield Average Life
FG C03728 4.00% 1/01/2012 01/01/2042 106-08 2.32% 4.13 years
FG Q05077 4.00% 12/01/2011 12/01/2041 106-08 1.75% 4.23 years


As you can see, both are very similar, and on the surface it looks like the first pool # C03728 would obviously be the better bond due to the lower dollar price (106-08) and therefore the higher yield of 2.32%. But as we remember from last week, the actual mortgage loans that make up pool # Q05077 are 150,000. This is what we referred to as a 150k max pool. That aspect causes this particular pool to “trade” 2 ½ points higher than pool # C03728.

Let’s dig a little deeper to compare the two. The next two Bloomberg tables show the projected yields given specific historical prepayment speeds. We will use CPR prepayment speed, which is defined as follows:

Conditional Prepayment Rate (CPR) attempts to predict the percentage of principal that will prepay during the next 12 months based on historical principal pay downs. As an example, if a pool is paying at 50 CPR this means that if it were to continue to pay at 50 CPR for the next year, half (50%) of the pool would be retired.

POOL # C03728:

3728

Click Here For Larger View (pdf)

As highlighted in the January pool, # C03728 “paid” at 40.2 CPR. As stated above, this means that if this speed was to continue, 40% of this pool would be retired after a year. You can begin to see the effects of using historical speeds to determine their effects on the yield going forward. If this pool were to continue to prepay at 40 CPR with a 106-08 price, your yield going forward would only be .65% with a 1.94 year average life. That is much different than the consensus yield expressed earlier.

C03728 106-08 @ consensus speed (345 PSA) 4.13 year average life 2.32% Yield
  @ January speed (40 CPR) 1.94 year average life 0.65% Yield
  @ 6 mo average speed (45 CPR) 1.67 year average life 0.15% Yield


The slower the speed, the higher the yield, but you also have a much longer average life and duration. At faster speeds you have lower yields along with shorter average life and durations. As you can see from the table if this pool were to prepay @ 50 CPR, your projected yield turns negative (-.379%).

Now let’s take a look at pool Q05077 (150k max pool)

5077

Click Here For Larger View (pdf)

This pool trades 2 ½ points higher and as we look at it you will begin to see why. The premise is that these mortgages are less as likely to refinance as the embedded costs of refinancing a smaller balance mortgage. Let’s look at a simple example:

150,000 balance mortgage @ 4.00% is a monthly payment of $716 per month

150,000 balance mortgage @ 3.00% is a monthly payment of $632 per month

This would result in savings of $84 per month. If you figured about $2,500 in closing costs, it would take 2 ½ years to make up the difference. Not a great incentive.

Getting back to our yield calculations on pool # Q05077, we now know to look at the historical CPR speeds. Last month this pool paid @ 17CPR and if it continued to pay there, this would result in a 1.97% yield with a 4.76 year average life. This is much closer to the earlier estimate.

Q05077 108-24 @ consensus speed (345 PSA) 4.23 year average life 1.75% Yield
  @ January speed (17CPR) 4.76 year average life 1.97% Yield


This pool has much slower prepayment speeds, which has resulted in a better yield, despite costing 2 ½ points higher, along with a steadier average life profile. This is a much easier asset to manage in a portfolio given the steadier profile.

So what are the key points to take away?

When purchasing a car one would never (I hope) tell a car salesman how much you can afford per month. As an educated consumer, you want to know how much the car costs first, and then you make the decision to finance, lease, or pay cash. You want to be the one in charge of the negotiations, not the dealer. The same holds true when looking at MBS pools. One of the worst things an investor could do is tell their broker, “This is what yield I am looking for?” As we have shown, you can make a certain yield “fit” with a certain price and prepayment speed.

MBS securities are a great option for a credit union portfolio to add incremental yield to their investment portfolio, but the portfolio manager needs to be aware of the risks and ask the right questions to make an informed decision.

  1. What prepayments speeds are you using and how does that compare to the past and current speeds?
  2. What is the yield at current prepayment speeds?
  3. Does this bond fit my duration needs at the current prepay speeds?
  4. Does this pool warrant a “pay up” versus other pools that are available?

The goal is to make sure that each investment manager is aware of the underlying risks of certain securities. Educating yourself and performing the necessary analysis will go a long way in improving the performance of your investment portfolio.

 

 

 

Feb. 4, 2013


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