Despite the 15-year sector presumed to have less negative convexity versus 30-year collateral, recent research has said that it might not be an effective hedge against rising volatility. Further, analysts said that extension protection from the 15-year sector would be in less demand in the near term.

While evidence strongly shows that 15-year collateral still has better convexity compared to 30-year product and will therefore outperform if the market breaks out of its recent range, the market's response to shifts in volatility remains unclear, said a recent Merrill Lynch report.

Merrill stated that while it is apparent that the market assigns value to the better convexity in 15-years, it is not clear whether the sector responds to changes in implied volatility. The firm's analysis showed that there was really no relationship between the level of implied volatility and 15-years.

In other words, the 30-year/15-year relationship is not a very good way of expressing a view on implied volatility. "Investors should therefore bear this in mind when considering when the 15-year sector makes sense as an alternative to 30-years," wrote researchers, arguing that investors should only consider the 15-year sector if they expect a real move, and not when they just think implied volatilities are too low.

In a separate report, analysts from Deutsche Bank said that their OAS model indicated the 30-year sector has actually cheapened compared to 15-year collateral in the past few months. Most telling was a time in February and March when extension protection was in high demand and 15-years considerably outperformed. While the OAS spread has moved back towards the mean in the past month, researchers said that they view this as merely the momentum of buysiders leaving 15-years and moving more into 30-years.

Moreover, there will be less demand for extension protection from 15-years going forward as the average dollar price of the mortgage market falls. This could happen if rates rise. This will also occur gradually over the next year as higher coupon mortgages are replaced by new, lower coupon mortgages brought about by the current refinancing wave.

Supply and demand for these coupons also serves as a consideration, said Deutsche. Demand for 30-year 5.5s product is still high from CMO dealers, banks, and money managers. On the other hand, though demand for 15-year 5.5s remains decent, banks and other financial institutions seem currently to be less involved with the 15-year sector due to the lower yield. Therefore, from a supply standpoint, net supply of 15-years is still considerable. This should stop an unwanted squeeze in the 15-year 5.5 coupon from hurting this trade, they said.

Analysts suggested buying 30-year 5.5s and selling 15-year 5.5s due to several factors. The OAS now appears attractive for the 30-year compared to the 15-year coupon. Aside from this, net supply for 15-years remains high, as mentioned earlier. Lastly, the massive yield pickup of 30-year 5.5s should make up for their worse convexity numbers.

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