I investors should buy FNCL 6.5 while selling FNCL 5.5, duration hedged with 10-year swaps, Barclays Capital analysts said last week. They also suggested for buyers to unwind existing FNCL 5.5/FNCL 6 trades.
Analysts noted that housing market weakness is currently a major concern for many MBS investors. Recent data from the National Association of Realtors show that the sales price of the median home dipped 9.7% over the past year. Although they acknowledged that this data series could be considered rather volatile and analysts do not really put value in its significance, the data still reflects a continuing weakness in the housing sector.
However, they also said that housing concerns have not really translated into changes in relative valuations. Usually, a weak housing market causes a significant slowdown, which should help up-in-coupon trades. But, several weeks ago, analysts had moved down in coupon on a tactical basis (FNMA 5.5s versus 6s) because discount MBS had underperformed considerably as a result of bank selling that occurred in September. Since then, discounts have taken back some of their losses and the firm's long-term up-in-coupon trade recommendation once again looks attractive, analysts said. This is why they are implementing the two changes to their our model portfolio mentioned above
Analysts further discussed the trade of buying 6.5s while selling 5.5s. Using the firm's long-term speed projections, analysts estimate the hypothetical price effect for the FNMA 6.5/5.5 swap at different levels of home price appreciation. The firm's data showed the implied price change for the FNMA 6.5/5.5 swap given its lifetime speed projections for different housing scenarios - assuming a constant Z-spread. Analysts benchmarked their price changes to the 8% HPA scenario, which is the level during the past year. The 6.5/5.5 swap currently looks fair on the firm's regression models. But these regressions factor in a much stronger housing market. Clearly, as weaker levels of HPA get priced into the 6.5/5.5 swap, the trade should benefit. Analysts recommended sizing this trade as follows: Buy $100 million FNCL 6.5%, sell $100 million FNCL 5.5%, and receive fixed on $28 million 10-year swaps.
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