In a report released March 6, Barclays Capital MBS analysts said that with a great deal of investor attention focused primarily on the largest coupons, relative-value opportunities in the smaller coupons are left unnoticed at times.
Analysts believe this is the case with the FNCL 7% coupon. Although the largest pass-through accounts would probably not get excited about this trade, there appears to be enough of this coupon outstanding to make a reasonably sized trade (at the $100 million level) viable.
Analysts said the coupon swap is similar to an IO trade. It's like purchasing the 7% coupon and selling the 6.5% coupon, effectively leaving an investor with 50 basis points of an IO. However, this does not consider other variances between the two coupons, such as delivery characteristics.
An IO has negative duration, most of it concentrated around the 10-year point of the curve, and rises in value with the 10-year swap rate, analysts explained. Since the coupon swap is similar to an IO, it should also follow the 10-year swap rate.
Analysts added that the coupon swap followed the 10-year swap rate in the second half of last year. However, in the past few months, that relationship has weakened significantly, creating an opportunity for purchasing FNCL 7% versus FNCL 6.5%.
There appears to be no issues linked with shorting the 6.5% coupon. Analysts said it is now trading at roughly half a tick over carry in the roll market. Also, even if servicers move up in coupon to shed duration, they will use the coupon closest to par, namely the 6%, and not the 6.5%. The trade also seems appealing based on Barclays Capital's OAS models. Also, the 6.5% coupon OAS has tightened almost 13 basis points in the past three months while the 7% coupon OAS has widened roughly 12 basis points.
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