For investors who want to take a view on the housing market, Bear Stearns analysts have suggested moving into new 5.5% Trust IOs. These bonds are the most leveraged instruments to the housing market that are currently available in the agency MBS universe, they noted. In addition, there is decent size, good liquidity, no credit risk, and the investor can earn positive carry while waiting for the housing story to play out.
Because new Trust IOs derive their cash flows from recently originated loans with note rates that are below current 30-year mortgage rates, they are less sensitive to interest rate fluctuations like IOs with current or above market coupons, and so should track the direction of the housing market, analysts said. Therefore, if home price appreciation continues to slow, it will take longer for borrowers to do cash-out refinancings.
Bear Stearns supported this by analyzing the impact on the pricing of various IOs under different home price appreciation rates of 0%, 2%, 3.5% 5% and 7%. Their analysis also considered different lengths of time for the appreciation: 12 months and 24 months. The base case is 18 months. The results were expected: the lower the long-term home price association rate used, the more the Trust IO goes up in price; and the faster it takes to get to the long-term HPA rate, the more valuable is the Trust IO.
Their analysis also showed that 5.5% recorded the greatest sensitivity to variations in the housing market: appreciating 38/32s in the most dramatic slowdown - 0% HPA in 12-months, and depreciating 26/32s in the most limited slowdown - 7% HPA in 24 months. Meanwhile, 5% and 6% IOs seemed to be somewhat less sensitive to home price appreciation, analysts said. They attributed this to various factors, including the fact that IOs gradually become more sensitive to refinancings as they move closer to par and that as rates move higher, borrowers become resistant to cash-out refinancings since they will be paying rates substantially above what they were used to.
Bear Stearns warned, however, that the interest rate risk of investing in Trust IOs must be actively managed as they have a very negative duration and negative convexity that leads to dramatic responses to large moves in rates. Analysts suggested to combine a new discount Trust IO with a duration-matched position in TBA, to combine a new discount Trust IO with a duration-matched position in seasoned discount PO, as well as to combine a new discount Trust IO and receive fixed on a duration-matched interest rate swap.
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