Barclays Capital analysts last week suggested that investors look at loan balance discount paper. The pay-ups are currently very low, and analysts believe the sector can provide better extension protection versus the generic discount universe.
Why the focus on lowering extension risk? Cash-out refis have boosted speeds for generic discounts. However, analysts said that as the housing market slows and mortgage rates continue to rise, cash-out refinancings are expected to decline, causing generic discounts to slow more than loan balance MBS.
To support their theory, analysts looked backed at the year 2000, when the mortgage market was dominated by deep discount coupons, while home price appreciation held firm at 5% to 6%. The other period they reviewed was 1994 to 1995, when the market was deeply out-of-the-money and house price appreciation was weak at just 1% at 2%.
Currently, the loan balance sector is divided into three categories - low loan balance (LLB), medium loan balance (MLB) and high loan balance (HLB) - with an average loan size of $96,000 for the entire group. To try to provide a fairer comparison, analysts found out what the average loan sizes were in 2000 and over the 1994 to 1995 period. For 2000, it was $69,000, and for 1994 to 1995, it was about $51,000, according to their findings. With this information, analysts reviewed these periods' prepayment history.
Looking at 2000 first, analysts subdivided the average balances into $60,000 and lower and $60,000 to $70,000 for the 2000 period. The history showed the $60,000 and lower bucket was two to three CPR faster compared to generic discounts in 2000. Meanwhile, the $60,000 to $70,000 bucket was also faster than generics, but it was less than the lower bucket.
Analysts then considered the three CPR advantage on a current medium loan balance paper with a 5.5% coupon - which has a one tick pay-up and nearly a $4 discount from par. Under this assumption, they calculated that the carry advantage is nearly 12 cents or almost four ticks for year. In addition, if the market rallies, the collateral becomes more valuable as it traditionally has provided better protection from refinancings on premiums.
In terms of the 1994 to1995, the data also suggested slightly faster speeds compared to generics. There was limited data to aggregate around the $51,000 average, so analysts created two buckets $70,000 and less and $70,000 to $80,000, noting that collateral was more homogeneous back then versus currently. In this comparison, both buckets prepaid one to two CPR faster than the generics.
Analysts are not certain why speeds were slightly faster on loan balance paper versus generics, but they suggested that these homeowners "walk a thin line." Though some are able to move up in life, others fall on hard times, forcing them into delinquencies or defaults. In either case, "the outcome is faster speeds due to factors not connected to interest rates," concluded analysts.
Recent prepayment data suggested some divergence of loan balance paper and generics. Over the past six months, loan balance paper has started to pay faster compared to generics. Analysts expect this to continue and to pick up steam as housing slows and cash-out refis diminish. Given the current lack of pay-ups as well as historical support for faster speeds on discounts, analysts believe investors should take advantage of this opportunity.
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