With the current steepness of the Treasury and funding curves creating quite a favorable environment for carry trades, "the carry is king" mantra has once again permeated the mortgage-backed market, analysts said.

Currently carry, rather than option adjusted spread, is driving relative value analysis. This is apparent because those who consider OAS, specifically the GSEs, are not in buy mode (see related story on page 16). Further, analysts noted that there has not been much correlation between zero volatility spreads and volatility.

Generally, when there is a high correlation between the two, it means that those concerned with OAS valuations are the ones driving mortgage spreads. So when mortgage spreads widen because of increased volatility, this implies that the people who are buying mortgages are pricing in the volatility and, in turn, are also OAS investors.

"We have not seen much correlation between zero volatility spreads and volatility for quite some time," said James Nimberg, an MBS strategist from Credit Suisse First Boston. "I think what is specially true is that the correlation has dropped as Agency purchases have gone down or as Agency OAS has tightened. The ultimate OAS buyers out there are the Agencies and they have clearly stepped out as evidenced by the decrease in Freddie Mac's net portfolio."

In come the banks

In the absence of those driven by OAS, carry buyers - banks specifically - have dominated the market. Traditionally, these financial institutions have not really paid attention to OAS valuations or cared about the impact of volatility on mortgages.

But for how long will this interest last? Analysts stated that a lot depends on the Fed, which has signaled that it is not in a hurry to move its bias towards tightening, thus creating a favorable environment for carry players to buy mortgages.

And as long as the curve remains steep and banks remain unwilling to buy corporate securities or make loans, continued strength in the MBS market can be expected. However, CSFB's Nimberg said that these factors do not mean that there is a lot of upside from here.

"I think the biggest problem is that by the time people have figured out that banks have stepped out and that they are not buying anymore, it would just be a stampede," he said. "Carry is still king and will remain king until it isn't anymore, and that is going to be an ugly day."

Carry and the IO market

Carry is also a big factor in the IO market. IOs, which are negative duration instruments, are hedged by buying positive duration instruments such as passthroughs. In using passthroughs to hedge IOs, the position benefits from the positive carry of the hedge position and the IO, and the strength in passthrough dollar rolls only enhances the positive carry of the trade.

This is in part why the IO sector reflects the "carry is king" mindset of the mortgage market as a whole. Another important factor is short-term prepayment expectations.

In a report from Countrywide Securities released last Tuesday, analysts wrote that current levels in the IO market are driven by short-term carry considerations, and not longer-term relative value concerns.

"Arb accounts and other players in the IO market are not being driven by general rich/cheap evaluations as much as by the ability to hold and finance securities to maximize returns from carry," they wrote. This is why cusp and premium IOs seem cheap by a number of measures that include dollar price multiples and OAS.

They added that the current prepayment environment, which is characterized by a very steep sloping prepayment S-curve and a comparatively fast seasoning ramp, makes carry-adjusted returns on discount IOs both higher and more predictable in comparison to those backed by cusp- and premium-coupon collateral.

According to Countrywide, this also suggests that these conditions will likely remain unchanged until realized prepayments on premium coupons slow down considerably. Assuming the curve remains steep, carry on higher-coupon trusts will then become both greater and more certain, and relative-value trades will then have a lower opportunity cost.

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