SAN FRANCISCO - With the mortgage market experiencing volatility right now, hedging strategies become important in portfolio management. At the Mortgage Bankers Association Secondary Market Conference 2005 held here last week, participants at the Pipeline Hedging Strategies panel discussed the market issues making it necessary to find efficient ways to hedge.
Volatility is a key issue, particularly in the MBS market. Walter Schmidt, manager of mortgage research at FTN Financial, said that uncertainty regarding the timing of Federal Reserve rate hikes is causing a lot of volatility in the MBS market, specifically at the front-end, thus affecting the hybrid ARM sector. He said that the themes of the market include: making hedge ratios a little longer, the growing ARM share, and the increasing importance of specified pay-ups - he emphasized that if investors are merely selling into TBAs, they "are leaving money on the table."
Schmidt added that the MBS duration drift is making hedging dicey. "Since the mortgage market has a high degree of volatility, it is difficult to put a strategy in place and to just leave it," he said, explaining that the sector is in the unprecedented position right now where it is concentrated in two coupons: 30-year 5.5s and 5s. He stated that currently the 5.5s comprise 35% of the 30-year market while 5s comprise 20%, adding that 33% of the market is currently refinanceable. Schmidt stated that a 50 basis point rally from here presents more risk than a 50 basis points sell-off. A 50 basis point decline in rates will make even the 6.5 coupon and higher, which currently comprises 16% of the market, refinanceable. "Hedging the 30-year portfolio is no longer cheap; as volatility rises the cost of hedging goes up," Schmidt said
Another theme that Schmidt focused on is the richness of the MBS sector relative to Agency debt. He identified the 4% 10-year Treasury rate on the low end and a 4.4% rate on the high end as the breaking points for spreads to widen. At 4.4% and higher, extension risk becomes an issue, he added. He enumerated the other factors that could cause a major widening, including another refinancing wave, a major sell off caused by the 10-year Treasury going up to 5%, the revaluing of Chinese currency, and the GSEs no longer being a buyer of last resort.
Schmidt also noted that the 30-year MBS sector is rich versus 15-years on a swap basis, adding that spread widening would likely occur first in the 30-year sector so he suggests making hedge ratios longer. In terms of the growth of the ARM market, Schmidt mentioned that both GSEs are currently buying more ARM product, making the fixed-rate portion of their portfolios shrink. Schmidt stated that one advantage of moving into ARMs is that one does not have to change hedge ratios as often. Additionally, the incentive to refinance has less of an effect on ARMs than fixed-rate product. There is also more certainty in terms of prepayments because although prepayments are fast on the ARM product to begin with, ARM speeds do not accelerate as much compared to fixed -rates.
Another thing that Schmidt emphasized is that if the market does not delineate between products and merely sells into the TBA sector, then investors lose out on some yield. He singled out low-loan balance and 100% investor properties as sectors where investors can currently take some profit. He also recommends the up-in-coupon trade.
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