In their Securitization Weekly Overview, Bank of America Merrill Lynch analysts highlighted the “unusual” co-existence of the risk-on and risk-off trades that has emerged this year.
In 2011, ABX prices came down as treasury yields moved lower. However, thus far in 2012, the 10-year treasury yield is hovering at the historic 220-year low as of June 1. At the same time, the ABX price is up by 17.6% over the same period.
BofA Merrill analysts characterized the significantly low 10-year treasury yield as suggesting the markets are on a “full blown “risk-off” mode”. At the same, the securitized sectors are in a “risk-on” mode given subprime RMBS' and more specifically, the ABX's recent performance.
This co-existence can be explained by two notable side effects of the U.S. bond market’s role as a “flight-to-quality destination” from the crisis in Europe.
First is that the resulting low yields in treasuries have been partly passed through to mortgage rates, which provided incremental rate stimulus to the U.S. economy and housing sector. This is why the fundamental story for mortgage credit received some boost from the European crisis recently.
Second is the erosion of yield in treasuries that has only pushed the search for incremental yield through credit. Given ABX prices’ steep acceleration that happened after the June 1 drop in yields, they believe that this timing suggests that the risk-free rates will be “uncomfortably” low for a prolonged period.
After the sharp price moves in non-agency MBS in June, BofA Merill Lynch analysts deem it likely that there will be a pause or, at a minimum a slowing, instead of a continuation of these steep increases. Nonetheless, they also said that the price gains are sustainable and that the non-agency MBS, specifically last cashflow subprime, will stay fundamentally cheap, especially in with the current low yields. This value, they said, also applies to other higher-yielding credit sectors such as CMBS and CLOs. They believe that “the “risk-on” exposure to these sectors is still warranted.”
In terms of the risk-off trade, they believe that consumer ABS and the agency MBS markets remain attractive. Similar to the reasons they name for non-agency MBS, including the factor of net supply and favorable prepayment dynamics, BofA Merrill analysts predicted that the most expected path for agency MBS is for further spread narrowing, despite the hurdles along the way to tighter spreads.