Though extension risk has been the buzzword in many MBS market commentaries and analyses, some investors say that while it is a concern, it is not yet a major factor, as this risk has already been priced into the mortgage-backed market.

And despite extension fears, people remain positive on the sector.

"We still like mortgages even with the talk of extension risk," said Peter Perrotti, senior vice president and director of MBS at Hartford Investment Management Company. "It has been a good year for mortgages. Implied vols are relatively high, OASs are attractive and absolute spread levels are very nice right now. So we still like mortgages, especially if you compare them versus Treasurys and Agencies."

Indications from the FOMC

Extension became even less of an issue when Federal Open Market Committee (FOMC) voter Robert D. McTeer said in Prague last Tuesday that the Fed is in no hurry to change its bias to tightening.

In a statement to some reporters, the president of the Federal Reserve Bank of Dallas indicated that inflation pressures should continue to ease in the coming months, allowing the Fed room to hold off on raising interest rates in the near future.

"I put a lot of emphasis on what McTeer said today," Michael Cheah, a fund manager at SunAmerica Inc., said last Tuesday. "Right now I am not concerned with extension risk. I think a lot of the bad news, a lot of the Fed tightening has been built into this market so I am prepared to look to buy. I think that in terms of risk versus reward this is a very good entry point."

In general, investors are bearish on the market and have taken the conservative position by going up-in-coupon -- a defensive posture. But since the market has already priced in a very aggressive Fed, it is difficult to take profits at this point. Cheah believes that there is good opportunity in going down in coupon.

"I likenow to go down-in-coupon because the low coupons have been so badly beaten up," said Cheah. "And if the Fed is right to tell us that there is no urgency to tighten, the low coupons should do very well. I put a lot of weight on what McTeer said. I don't think he is trying to mislead the market."

On convexity hedgers

The market has been talking about extension risk since the end of last October, when the mortgage index duration extended 1.25 years. Many mortgage investors have been uncomfortable that the market has been in a range trade. Experts stated that for the first two days of last week the market was sitting against the higher end of that range.

Perrotti said that if the 10-year Treasury market breaks through the 5.45% to 5.50% level, there would be more extension-related trades, especially on the part of convexity hedgers, who sell fixed-rate assets (primarily Treasury notes) and receive fixed swaps in order to rebalance the duration of their mortgage portfolios. He said, however, that so far this year, there has not been a lot of activity on this front of yet.

"As we backed up this month, the 10-year swap spread actually came in," said Perrotti. "Normally when you have mortgage hedge investors coming in, you would essentially get that to push out. Convexity or extension has been a topic in many research papers but the market has not been overly concerned about it as long as we hold these 5.50% levels on 10-year Treasurys."

He added that the near-term focus on extension risk is more of a concern from a technical trading level as opposed to the absolute extension risk of the securities.

7s are in

As market talk moves towards extension risk, investors who have stayed in the mortgage market have started moving up in coupon.

Many of them are turning towards 7s, the preferred domain for investors who want to pick up yield and protect against extension.

In fact, the market has seen a squeeze on the front months for 7s, where the dollar roll has been very attractive because of increased investor demand. Aside from this, security has not been that good on coupons above 7%. Fannie 7.5s, for instance, currently do not have the same month-to-month yield.

Perrotti said that his firm has a bias towards Fannie 7s because they tend to be well supported in the market right now.

He added that 6.5s, to a lesser degree, have also done very well, as a lot of the mortgage market is currently concentrated in 6.5s . Perrotti said that there is not a lot of room for 6.5s to appreciate, but at the same time they also currently have some decent yield profile.

No place to hide

Citing a UBS Warburg report, an earlier edition of ASR (See 03/19, p 13) pointed out that it has become more challenging for mortgage investors to avoid extension risk or shorten duration in their portfolio because of the changing MBS landscape. Investors can no longer readily use the two "traditional prescriptions" for avoiding extension: moving up in coupon and moving into 15-year balloon collateral.

Moving up in coupon has become more difficult because of coupon concentration in the mortgage market.

In terms of moving into 15-year collateral, it has become more difficult because as refinancing activity begins to dwindle, the percentage of borrowers who will take out 15-year mortgages naturally diminishes, thus creating less 15-year supply.

Aside from this, experts said that 15-years do not offer a lot of yield. So as refinancings start to trail off, people begin to move away from 15-year bonds and flock to higher-yielding securities, which tend to do better folowing refi booms.

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