The Barclays Capital index team said that Federal Reserve agency MBS purchases would remain part of the aggregate index, which has various implications, according to the team.
 
Fed buying has focused on conventional 30-year 4.0s and 4.5s. Currently, there is $313 billion ($71.5 billion in 4s and $242.8 billion in 4.5s), with these two coupons accounting for just 8% of the agency MBS fixed-rate index. With May issuance and most of June issuance out, this number should grow substantially, according to Barclays.
 
It is estimated that conventional 4.0s and 4.5s will increase by $340 billion (reaching $179 billion in 4.0s and 474 in 4.5s) over the next three months. This  would represent pools issued in May, June and July. This is why even if rates stay at these levels, conventional 4.0s and 4.5s should form around 14% of the agency MBS fixed-rate MBS index.
 
Barclays analysts expect around $655 billion of conventional 4s and 4.5s to be part of the agency MBS fixed-rate index. Of these, around $315 billion is currently in the index, the rest are pools that should show up over the next few months.
 
This is why it is not anticipated that indexed money managers currently own enough 4.0s and 4.5s to be in line with the index. Given the increased mortgage volatility over the recent weeks, it is expected that these managers will try and track the index more closely, which should benefit 4.0s and 4.5s. These coupons have taken a beating over recent weeks.
 
The up-in-coupon trade has performed extremely well recently, driven by extension fears in 4.0s and 4.5s. But Barclays believes the trade is overcrowded and overdone, and when that trade has turned over the past six months, it has done so quite sharply. The 5.0/4.5 swap looks rich by historical standards. This is why the firm recommended going down in coupon including buying 4.5s against 5.0s on a duration-neutral basis.
 
Lower coupons could also benefit from their inclusion in the index. With a majority of 4.0s and 4.5s being owned by the Fed, demand-supply dynamics favor lower coupons, and more than 80% of 4.0s and 65% of 4.5s are owned by the Fed. With indexed money managers making up 20% to 25% of the mortgage universe, there are barely enough 4.0s and 4.5s to go around.
 
In addition, 4s pose a bigger problem. As of the end of May, there was $100 billion of 4s, with the Fed having bought $82 billion of these. The Fed has bought 4s forward as well, with its purchases reaching $142 billion. Given that around $179 billion in 4s are expected to be produced over the next three months, this leaves only $35 billion for the rest of the market. For 20% to 25% of the total agency MBS investor base, a slice of $35 billion is very unlikely to be enough.
 
Compounding this problem is the likelihood that new 4s are not going to be produced. The economy seems to have stabilized, and mortgage rates have risen 125 basis points from the lows, which is where the 4s were created, the firm said. The result is as index managers get used to the idea of 4s and 4.5s in the index, 4s might roll special for a while because of the lack of availability.
 
Even as Barclays expects a down-in-coupon move, the underweight call on the basis remains the same. The two coupons at the heart of the issue — 4s and 4.5s — have very little influence on the nominal basis, given their dollar prices, Barclays said. If some investors move out of 5s into lower coupons, it could add to the widening pressure.

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