BOTW 10: MBS for Fun and Profit

Pairs trading MTBA vs. MBB, the MBS ETFs, generates tidy risk-adjusted outperformance with or without leverage

Building on our pairs trading backtest from last week, we thought we might look outside of the equity space into area we don't usually examine: bonds! We might be called Options, Stocks, Machines, but that doesn't we can't venture into the fixed income and alternative asset space once in a while. Today, we'll look at a pairs trade between the mortgage-backed securities (MBS) ETFs MBB and MTBA. MBB is managed by iShares and tracks the Bloomberg U.S. MBS Index. This index is comprised of investment-grade mortgage-backed securities issued and/or guaranteed by the US government; that is, Fannie Mae and Freddie Mac, the so-called GSEs (government sponsored enterprises), and Ginnie Mae. MTBA, managed by Simplify, also tracks the Bloomberg Index, but tends to focus on newer securities with higher coupons and yields compared to the index. Importantly, MTBA will typically invest mostly in Fannie Mae bonds as opposed to all those mentioned above.

MTBA tends to have a lower duration than MBB. As of most recent disclosures on the managers' respective websites, MTBA has a duration of 3.87 vs. 5.47 for MBB. For those who've forgotten their CFA curriculum, duration is the linear relationship between the change in interest rates and change in the bond's price. Higher duration, more sensitivity. Notice we mentioned linear relationship. The other part of this is convexity, as the price-yield relationship is actually non-linear. Convexity aims to account for that non-linearity and in vanilla bonds is usually positive. In mortgage-backed securities, that is not usually the case. This is due to pre-payment risk, the risk that the borrowers will pay-off their mortgage and the investors will have to redeploy that capital at lower implied yields. This results in negative convexity, which means as rates fall, prices increase at a decreasing rate, instead of at an increasing rate, as one would see in plain vanilla bonds.

If all that sounds like a lot to absorb, don't worry too much. As quanttards, we don't need to understand the fundamentals! We only need to know what the data tell us. That said, one can think of this as a pair between active (MTBA) and passive management (MBB), a pair between short (MTBA) and long (MBB) duration, or simply non-equity exposure.

Before we get to the data, note that we recently launched a new blog on all things covered call. As an incentive for early adopters, we're offering 45% off the annual plan forever. Click the link below to take advantage of this deal, which will expire on April 25. Thanks!

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First post: https://buywriteinthemoney.substack.com/p/welcome-to-in-the-money