SCI hears from an US MBS buyer about what he likes in the market... and next week what he doesn't

Karlis R. Ulmanis, CFA, is a portfolio manager at DuPont Capital. In these waning days of summer, he gave an hour of his time last week to sit down (virtually, of course…) with SCI to discuss where he sees value in the current somewhat fractured and definitely jittery MBS market, agency and non-agency. We publish the first half of the interview this week, under the title “Things to like.” This deals with where he currently sees value.The second half of it - “Things not to like” - will be published next week. Spoiler alert: it’s a  longer list...

Ulmanis is responsible for managing fixed income sector weight strategies and mortgage portfolios and also the development, implementation and execution of mortgage and corporate investment strategies for fixed income sector allocation strategies.

Prior to joining DuPont Capital in 1997, he was vice president and manager of quantitative research at Fidelity Federal Bank, and before that as vice president and senior investment analyst at First Interstate Bancorp. He went into the financial sector in 1993, before which was senior project engineer for Hughes Aircraft Company.

Ulmanis holds a B.Sc. in mechanical engineering from the University of Illinois, an M.Sc. in aerospace engineering from the University of California, and an M.B.A. from the University of Southern California.

He manages $740M which is benchmarked against the securitized benchmark within the Bloomberg Barclays Aggregate and Intermediate Aggregate indices.

Over $500m of his portfolio is denominated in agency mortgage TBAs and pass-through pools. The remainder is composed of $120M non-agency structured RMBS (including subprime, AltA, Prime, CRT and RPL) and $110M structured non-agency CMBS.

Things to like

The coupon roll

Liquidity in the TBA market is currently good, but one of the biggest areas of potential money-making can be found  in the coupon roll, where positive carry is as good as it’s been for eight years or more.

Consider this: in July, the GSEs printed $152bn of new agency 30-year paper, but over the same time period there was $184bn of prepayments. This left the market with a $32bn shortfall of 30 year agency MBS. But this scarcity was deepened by $91bn of purchases by the Fed in an effort to keep the market liquid.

So, the net availability of 30-year MBS paper was negative $122bn, forcing current paper deep into special territory as market-makers and investors hunted down paper to cover shorts and so on. For example, the August/September roll in 2% paper pushed out to a pick-up of 8bp, while 2.5% paper was 13bp special and 3% paper up to a vertiginous 25bp.

“This is very lucrative for investors than can hold TBA paper and aren’t locked into holding pools. In fact, it’s one of the biggest opportunities in the MBS sector. I don’t remember the roll being this special since about 2012,” says Ulmanis.

Market participants that need to get their hands on current month’s supply will pay inflated prices for the privilege, leaving investors that are not market-makers like Ulmanis in the cat bird seat. They can pick up immediate positive carry with little risk.

The only factor which might alter this happy picture is the money market rate at which the position is funded, but, as rates are very low here the upside risk is limited.

Coupon exposure

With mortgage rates at all-time lows, there is significant prepayment risk in the higher coupon agency MBS paper and as a result Ulmanis is under-weighting the higher coupons in the 3.5%/4% range and over-weighting the lower coupons in the 2.5%/3% range.

This is also makes sense from the perspective that the juice from the roll is earned in the lower coupon TBAs.

Non-agency RMBS

Slim pickings here.  Ulmanis likes fixed rate, legacy bonds with a low LTV, attractive coupon and robust credit enhancements, but these are like hen’s teeth.

Simon Boughey