With hybrid ARMs comprising a more considerable share of mortgage production compared to several months ago, analysts are now egging on investors to take advantage of this supply situation and to move into hybrid product for relative value.
Though in dollar-volume terms mortgage supply has gone down both on the fixed-rate side as well as on the hybrid end, the drop in the hybrid sector has been significantly less. This situation has caused widening in the sector's spreads seen in July and in early August. Although analysts say supply in the sector has dropped since then, causing nominal hybrid spreads to tighten about 20 to 25 basis points, OASs in hybrids are still approximately 25 basis points wider relative to fixed-rate paper - making it a decent relative value story, said analysts.
A UBS Warburg report released last Wednesday said that while hybrid ARM production declined considerably less versus fixed-rate products, investor demand for the paper has not noticeably risen. This has caused the sector to cheapen. "At this juncture, short duration investors should certainly look at hybrid product," wrote analysts.
Increased ARM share vs.
UBS cited Mortgage Bankers Association (MBA) refinancing indices from 6/13/2003 (which was the height of the rally) and the index results as of 8/29/2003. The report stated that at the peak of refinancing activity in mid-June, the MBA refi index came in at 9163 while the more recent figures came in at 1982. More telling is the fact that the MBS composite index dropped to 629 from 1702, which is equivalent to a 63% dip.
In terms of the ARM share in applications, while there was a 67% decline in fixed-rate applications, ARM applications only dropped by 40%. This is why ARMs currently comprise a larger share of total production, the report said. UBS stated that ARMs now represent 23% of the total number of loans, in contrast to only 14% at the peak of the rally merely 11 weeks ago - causing ARMs to cheapen relative to their fixed-rate counterparts.
The firm does not believe, however, that ARM technicals could worsen significantly from here. In fact, based on a regression analysis (that used variables such as where the current coupon mortgage rate is at and the shape of the mortgage curve), analysts said that the ARM share is actually higher than what they projected. "Thus we do not expect the ARM share to increase considerably more, until ARMS richen up relative to fixed-rate mortgages or the market sells off," wrote analysts.
The report also compared the relative value of ARMs versus investment alternatives. UBS concluded that Agency 3/1s, 5/1s and 7/1s all appear to be reasonably attractive. Agency 7/1 ARMs are currently considered to be the most attractive versus CMOs. Meanwhile, Jumbo 5/1s look even cheaper compared with their Agency counterparts. The Agency 3/1s have been seen as quite rich throughout most of the year, and are currently somewhat cheap. Jumbo 3/1s are considered significantly cheap to their Agency counterparts, said UBS.
Merrill agrees on hybrids
In a Merrill Lynch report released last Wednesday, analysts stated that hybrids offer a cheap alternative for those seeking extension protection or investors looking for reduced average life variability.
"With the increasing volatility of interest rates in recent weeks, many investors may be looking for securities with less average life variability and duration drift for their MBS portfolio," wrote analysts.
They said that one way to reduce average life variability is to move into collateral with a better convexity profile such as hybrid ARMs and Alt-As. For instance, the report said that hybrid borrowers might often prepay or refinance their mortgages before the reset date, resulting in higher turnover rate versus 30-year product. However, when there are deep-in-the- money incentives, hybrid rates and comparable 30-year collateral start to converge.
The analysts compared relative value in hybrids with CMOs (30-year and 15-year sequentials as well as short intermediate PACs). They compared the amount of pay-up required to reduce average life variability in these securities.
Merrill's report summarized a three-part approach for comparing CMOs with hybrids when there is no common OAS model for the sectors on which to base the comparison. Analysts estimated the prepayments for the various sectors, applied these prepays to calculate the average life variability and, lastly, compared the average life variability with the spread.
Based on this analysis, analysts concluded that hybrid products looked cheaper compared to the types of structured CMOs utilized in the analysis.