With mortgage rates rallying continually to new record lows, the Federal Reserve using MBS paydowns to buy Treasurys, fears of a government-induced refinancing program, curve flattening risks and weaker rolls, investors have been spooked away from higher mortgage coupons.

As a result, valuations in higher coupons have become more attractive, said Barclays Capital analysts in a research note.

For example, the 5/5.5 and 5.5/6 swaps are trading around a half point below levels suggested by historical prices, and they are trading cheaper to their even-OAS implied levels by eight ticks to 10 ticks, analysts said. 

Up-in-coupon trades could also benefit by slower actual speeds than what is implied by the market currently, they added.

Given the market current risks that would increase down-in-coupon trading flows, analysts prefer a cautious approach limited to selective exposure to higher coupons. Specifically, they like the FNMA 5.5/5 swap.

In addition to attractive valuations, Barclays highlighted that the TBA deliverable in 5s has worsened in recent months with a shift to 20-30 WALA pools which are the among the fastest prepaying on the stack.

At this time the roll continues to trade over the break even carry by around 2.5 ticks at 7.75 ticks, but analysts expect it will fall to as low as five ticks to six ticks when the roll market begins to price to worse speeeds.

In addition, if the curve bull-flattens in the weeks ahead, prepayments on FNMA 5s should become even more responsive to rate levels.

Based on this outlook as well as the 5.5% roll trading close to breakeven currently, analysts "expect that 5.5s would trade somewhat better relative to 5s in a further rally," they said.

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