For investors anticipating the Federal Reserve's tightening cycle to end soon, Barclays Capital analysts suggest PAC-II inverse IOs. Specifically, with risks of an increase in prepayment speeds, they prefer inverse-IOs off of a PAC-II tranche. They believe the trade will allow investors to pick up yield, OAS and return, and, at the same time, be protected from a brief rally in rates that leads to slightly faster - albeit temporary - prepayment speeds.
As an example, they examined FHR 3041 SE. The bond is an inverse IO off a PAC-II tranche backed by 6.0% 30-year collateral. The coupon is 6.75 minus one-month Libor. The yield is 24.8% and OAS is 454 basis points. The underlying collateral has a current prepayment history of 17.4 and 20.8 CPR for one- and six-month speeds, respectively. At these respective speeds, the bond has a yield of 15.5% and 17%, calculate analysts. The yield is negative at its life speed of 24 CPR.
Barclays researchers looked at vectors as speeds influenced by rate levels, seasonal factors, and so on. They believe this is especially important since "this bond loves temporary fast speeds, which eat away at its supports, and let it benefit from eventual extension." In one scenario, they ran the bond at 22 CPR initially (their estimate of where the collateral should pay over the next few months if mortgage rates fall 25 basis points) before slowing it down to its life speed of 18 CPR. Assuming the faster speed runs for nine months, the yield is 16.2% with a 2.3-year average life. Extending the faster speeds to 18 months and 27 months, respectively, the yield increases to 19.6% (2.5-year average life) and 23.7% (3.2-year average life). Analysts noted that the yield improves on the longer, faster speed. Also, with a greater part of the companion paying off, the eventual extension benefits the bond to a larger degree. They also considered faster speed scenarios under varying lengths of time and concluded that: (1) the bond can withstand lower rates for long periods of times - as much as 12 to18 months - depending on the rally; and (2) the bond does not need a sell-off from current levels to outperform. However, rates and speeds must eventually return to current levels.
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