With a flattening yield curve on the horizon, MBS market participants are readjusting their expectations for returns. This is particularly true because investors have become used to passthroughs trading in a steepening yield curve scenario, as was the case for a large part of the last three years, said analysts.

"One of the bigger risks we see to relative value trades in the market is from increased curve volatility," wrote Lehman Brothers in a recent report.

In the report, researchers estimated the extent of curve risk in typical mortgage trades executed in the mortgage-backed sector. "For most common trades in the market, we estimate that we are likely to see 50% to 60% of the effects of a flattening predicted by models," observed researchers.

Mitigating curve risk takes more than just hedging out exposure according to model projections, analysts said. One of the issues is that on a daily basis, the performance of most mortgage trades is not strongly attached to the slope of the curve. Aside from this consideration, adding a curve hedge will only further exacerbate the daily return volatility of the position.

Hedging out the curve for shorter-horizon trades is not worth the heightened volatility, Lehman stated. Even for an extended period, it may happen that the market won't fully price in the impacts of the curve shape. "A curve hedge should aim to hedge out only the risk that is likely to be priced in by the market," wrote analysts.

Lehman cited 30/15-year basis trades. Current coupon 15-year TBAs hedged with 30-year counterparts possess a steepening bias. This coupled with a 100 basis point curve flattening will make the swap lose 28/32s. To the extent that a flattening is not priced in (on an option adjusted spread), 15-year current coupons need to tighten 20 basis points versus their 30-year counterparts, said analysts. Analysts also mentioned 30-year coupon swaps. A flattening of the curve will likely cause progressive price compression in the coupon stack. In a 100 basis point flattening, for example, the firm's model predicts the price differential between 30-year 6s and 4.5s to compress by 33/32s.

Survival of the premiums

In a separate but related report, Bear Stearns argues that in a curve-flattening scenario, returns rely on three basic elements: price, cashflow, and at a distant third, reinvestment. With the three together, it may be surprising that shorter-premium MBS weather the flattening of the yield curve relatively well. While they initially take a hit in pricing, over time they make up for it through improved carry.

As short-term interest rates rise, mortgages with front-end principal get hit the most because of discounting. If two-year rates increase by 140 basis points in the next year (which is a repeat of 1994) and 10-year rates remain the same, prices in current 30-year premium passthroughs are expected to dip the most.

Although 10-year interest rates, for the most part, drive prepayments, a rise in shorter rates can have an impact as well. Bear Stearns said a flatter curve largely takes ARMs away from the refinancing equation. Analysts also pointed out that slower prepayments in all coupons result from rising short-term rates.

However, only premium coupons will really benefit from the principal extending. This is because premium coupons remain outstanding longer and their carry improves. The slower prepays also slow down the portfolio amortization of the price premium. These two events counteract the adverse effect on returns due to the significantly lower price.

By contrast, discount coupons prepay slowly to begin with, so very little excess interest will be earned over the year through extension. Furthermore, Bear Stearns argues that slower prepays eventually hurt returns from the cashflow by lowering the pace at which the discount principal is returned. In other words, the cashflow in discounts does little to minimize the price impact of a flatter yield curve. Though all coupons are adversely affected by the repricing of the remaining principal in a flattening scenario, only premiums exhibit a positive impact resulting from improved carry, said analysts.

Other mortgage-backeds

These conclusions apply to other mortgage-backed products. Longer securities that have little exposure to extension risk, such as well-structured 10-year PACs, are expected to perform well in a curve flattener.

In contrast, short PACs will likely respond differently to a rise in short-term rates as they will drop substantially in price because of the discounting of most of the cashflow at a higher rate. Aside from this, short PACs do not have the benefit of extension compared to premium passthroughs, explained Bear Stearns.

When interest rates rise, with the short end leading the way, Bear Stearns said that premium coupons are expected to be the strongest performers in the longer run. Despite the fact that they have a short average life, the extension in the interest as well as the principal will make up for the losses caused by the higher discounting rate. This is why, when moving up in coupon, the investor has a stronger chance to outperform lower coupons in a bearish flattening environment.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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