A Great Vouvray Notwithstanding, What Should Banks be Buying in the MBS/ACMBS Space?

With 45 degrees outside, in Chicago, it feels as if a spring is in the air. And this means that I will be presenting to you, my dear VinoComrades, a more balanced distribution of reds and white. During the cold months, I tend to drink reds almost exclusively, but during the warmer times, I love me some acidic and mineral French whites. And it is hardly a secret that a good Vouvray is just about on top of my list.

And on the top of that top of my list sits Philippe Foreau, and his mind-blowing Vouvrays. These are Loire Valley’s greatest white wines; shimmeringly pure, utterly scintillating expressions of the appellation’s famed tuffeau soils. The only drawback is that they typically require significant age to really strut their stuff. But not today!

Thanks to the warm and sun-soaked 2019 vintage, Foreau’s Vouvray “Clos Naudin” is ready to spread its wings the second you pull the cork. It’s got Foreau’s signature mineral refinement and electric tension, married to a breadth of golden-hued fruit you’d normally have to wait a half-decade or more to experience. Of course, like every iteration of “Clos Naudin,” it will also go the distance should you be patient enough to leave a few bottles untouched in your cellar. But with this gorgeous 2019, you’re in for a thrill ride at any stage of its life.

Domaine Foreau, Vouvray Sec "Clos Naudin"

Loire Valley, France 2019

Few regions and grape varieties are as synonymous as Vouvray and Chenin Blanc. In this tiny appellation to the northeast of Tours, Chenin reaches its highest highs. The sometimes rustic Chenin in Vouvray achieves a complexity and breed that places it definitively in the firmament of the world’s most noble whites. Local vignerons insist that’s thanks largely to the village’s signature tuffeau soil. Tuffeau is a particularly porous and chalky variant of limestone and is quite literally what the appellation is built on.

Vines grow on it, cellars are carved into it, even the houses in Vouvray are made from it. The porousness of means it drains freely, retaining just as much rainfall and nutrients as the Chenin vines need, while forcing them to struggle and produce small crops of concentrated fruit.

Now, my dear friends, having satisfied a perfectly natural urge to own and consume the most wonderful Vouvray that money can buy (don't worry - we will talk more about this beautiful wine later in this article), the question remains: what should Banks be buying in the MBS/ASMBC Space at the present time?

Today, I would like to highlight my top 5 favorite ideas for depository investors, who do not have clear expectations with regards to rate directionality, allowing an equal possibility that we rally from here (in rates), or selloff. Alternatively, they see a strong possibility that rates rally first, with a subsequent selloff in rates. This group of PMs also allow for a non-zero possibility that rates will remain in a tight range, with eventual curve steepening, when the Fed ends QT and/or begins to cut.

The reason I have chosen this specific set of investment expectations, is that this is what I have been hearing most often from our depository investors since the start of 2024.

Depository Idea #1: Front SEQ 5.5s off of G2 6s at Par

While this looks like a very generic idea, it does fit the investment outlook that we have prespecified, as it offers a very robust carry/yield profile, especially when it is considered per "unit" of duration. Given generally more robust OTM speeds of Ginnie Mae pools, extension is likely to be even less than the already manageable levels that can be seen on BBG or Yield Book.

This strategy does have one major weakness: G2 6s are likely to shorten when ITM. That being said, if the underlying collateral is chosen carefully, lower GWAC could create a "barrier" of ~50 bps. In addition, focusing on lower loan size Major pools could help as well. To be sure, this collateral will not withstand a 100 bps rally in mortgage rates no matter what we do to it (unless we select a more expensive specified story as collateral). Thus, investors, who are of the opinion that a meaningful rally is possible, may wish to avoid this strategy.

That being said, it is important to remind my readers that the "damage" due to faster prepayments will be manifesting itself mainly in the amount of unrealized gains which, in that case, are likely to be much smaller than suggested by the current OAD. From the book income perspective, pricing at or very near par will ensure the book yield stability (even if the book income will be enjoyed for a shorter time period, forcing investors to reinvest the paydowns at lower rates).

Yet, investors expecting, more or less, the status quo with respect to rates (or perhaps a small rally), might find this simple and widely accepted strategy to be perfectly suitable for their situations.

Depository Idea #2: Modest Discount Strip-Down SEQ off high DLQ G2 4.5s-5.5s

Here, we are dealing with seasoned collateral that is in the process of ramping up, with a considerable DLQ pipeline that really exaggerates the seasoning OTM speed ramp. Being priced at a discount (1-2.5 points depending on the coupon of the tranche and the underlying collateral), faster CPR will benefit book income considerably, even if rates remain unchanged or move up.

A rally (in rates) will bring the underlying loans closer to being ITM, thus accelerating negative incentive equity take out refinancing activity (very slightly). In the grand scheme of things, these added CPR are unlikely to be any more than 3-4%, thus allowing this structure to take a full advantage of price appreciation in a rally. Yet, the bulk of speeds will not be driven by rates, but rather by seasoning, as well as DLQ buyouts (or property liquidations).

Thus, in a selloff, investors are not likely to see much in the way of book income decline, and, by adding loans serviced by "fast" OTM servicers, such as Freedom, book income could remain unaffected or even go up.

Depository Idea #3: Partial Loan Balance, Large & Liquid 15yr 3.5s or 4s

Clearly, suggesting the purchase of 15-year MBS to a bank, is a rather predictable move. Yet, I have put a bit of a spin on this story. Firstly, I would recommend investors to be highly vigilant with respect to potential liquidity in the 15-year MBS, given an aggressively negative net supply in this sector. Thus, we suggest to focus on large and liquid pools (such as Majors).

In addition, we like moderate discount pools that will give us price appreciation in a rally, with a small boost to book income due to an increase in prepayments. Being fully extended, these coupons are highly unlikely to exhibit any lengthening in duration, should rates move the other way. To boost both, call and extension protection, offered by 15yr 3.5 and 4s, we prefer focusing on pools with high concentration of loans <$250k.

I know that these loans tend to prepay faster when OTM in the 30-year space. This advantage is even more pronounced in the 15-year universe, where investors can source large pools (mostly 2022 vintage) that will have very high share of LB loans. In fact, our readers will have little trouble procuring 15-year 3.5s and 4s with 35-45% of all loans falling into one of several LB buckets, thus enhancing their WAL and book income stability a great deal.

Depository Idea #4: FSEQ GNPLs, with High % CLC, High GWAC, & Low % HealthCare

Ginnie Project Loan CMOs have not been aggressively sought after by the banks as of late (but, then again, what has been?). Yet, I do believe that for investors with the set of investment beliefs highlighted above, this sector offers strong possibilities. The problem is that there is no real pricing model to re-assure ACMBS investors (especially those, who were previously burnt on 15 CPJ assumption, which didn't even came close to materializing).

Some investors resort to very punitive assumptions, such as pricing GNPLs at 2 or 3 CPJ for life. While on the short run, these speeds are entirely plausible, the rules of the multifamily gravity prevent us from using low single digit speeds for life of any GNPL.

Clearly, life expectations can be "boosted" by focusing on the high GWAC (>4.50% would be nice), as well higher share of construction loans (>20% of CLC is a reasonable threshold). Lastly, lower share of healthcare loans (<25%) is a great feature as well, as multifamily properties have been showing steeper aging ramps, even when completely OTM. Lastly, we are always happy to see TX in the mix. So, there you have it: the ultimate depository GNPL recipe.

No matter what, investors should always be comfortable with the worst case scenario, and should plan on this scenario as the base case. With the mix of features outlined above, we are comfortable saying that life speeds of 7 to 8 CPJ is entirely reasonable to expect. These speeds produce close to 5% Yields with 4-year WAL, and ~80 I-spread. Needless to say, with GWAC of >5%, even a modest rally in rates will result in a tiny increase in refis, while a more serious rally could impact prepayment speeds more seriously as well, leading to a considerable boost in book income.

Depository Idea #5: Seasoned 30yr 4s or 4.5s

The idea behind this story is similar to the logic expressed in the 15-year space. We want to focus on coupons that are just moderately below par that would hold up well in a rally. Even if they do shorten, they would have a book income "kick" from potentially faster prints. In the base case, however, they offer yield/carry that are superior to those of lower coupons. Lastly, if rates were to rise, the desired pools would have some features to boost the OTM speeds, thus limiting WAL extension in a selloff.

The major difference here is seasoning. Since depository PMs are generally averse to 30-year MBS, we have chosen to concentrate on seasoned pools in 4s and 4.5s. To make sure that a WAL profile fits most depository preferences, we decided to concentrate on 70+ WALA, which results in 6-7 years base case WAL, with ~8yr @ +300 bps.

Clearly, I prefer to have faster speeds, especially in 4s. Since one of the best ways to achieve this goal is by choosing pools with very low loan sizes (that, ideally, are serviced by Quicken), that is exactly what we would suggest. The resulting Yield is north of 5% with a very attractive OAS profile, and a strong performance in a rally, selloff, or in the rates unchanged scenario.

And Now, lets go back to France and finish our bottle of Vouvray already...

The Foreau family has been a leader in Vouvray for nearly a century. Since Armand Foreau established the domaine in 1923, the family has dedicated themselves entirely to the Chenin Blanc variety. The property has long stood at a modest 11.5 hectares, made up of two main parcels—“Les Perruches” and “Les Ruettes.” Vines in both parcels average about 45 years of age, and are farmed organically with annual plowing. Although the Foreau wines never carry vineyard designations, they’re both located in the choicest slope of the appellation, what the locals call the “première c?te.”

The Chenin grapes are direct-pressed whole-cluster, and then fermented spontaneously in barrels up to 30 years old in the family’s near freezing cellars. Thanks to the wines’ high acidity and the cellar’s temperature, malolactic fermentation never occurs, further enhancing the variety’s signature freshness. The wines are bottled mid-May following the harvest after a short aging period with minimal batonnage (lees-stirring).

In most years, “current-release” Foreau is brilliant, if austere, and dominated by its mineral structure. But 2019 was a warm, dry vintage, and yields were sharply reduced by an April frost. Low yields and sunny weather mean more fruit-driven wines, bringing this bottling into near-perfect, drink-me-now balance. The nose leads with the hallmark Foreau luster—pulverized limestone, chalk, sea salt, struck flint, lemon zest—rounded out here by golden apple flesh, pear skin, just-ripe white peach, white flowers, spiced honey, and fresh-cut hay.

On the palate, it’s medium-bodied and finely poised, glimmering with brisk acidity. Layers of fruit follow and flesh things out before a final wash of minutes-long minerality brings it to a close. It’s delicious now, a masterclass in what makes Chenin special. But like all Foreau wines, this will age comfortably for as long as you let it.

Thanks for Spending Some Time with me Today, and Enjoy!

Sincerely,

Kirill A Krylov, CFA, PhD