Citigroup Global Markets analysts noted recently that 30-year 6.5s have recently underperformed and the dollar roll has dropped. Analysts said this might be caused by the threat of future origination as primary mortgage rates have moved higher over the past couple of months. However, analysts think that increased supply will lead to rising demand. Thus, they recommended taking advantage of recent weakness in 30-year 6.5s by adding exposure to this coupon.
Researchers stated that a considerable source of demand for 30-year 6.5s is those that are hedging mortgage servicing rights. This asset has a negative duration, which is similar to a mortgage IO strip, with the most relevant reference interest rate being the primary mortgage, analysts explained. The most effective way to add positive duration in the primary mortgage rate is to purchase the current-coupon secondary mortgage security or just the par priced MBS. With 30-year 6.0s at $99 and 30-year 6.5s just over $101, an almost equal combination of 30-year 6.0s and 6.5s accomplishes this. Realistically, there are other risks as well as constraints that will hinder MSRs from being hedged just with MBS, and a considerable amount of MSR duration is hedged by receiving fixed on swaps, analysts noted.
To explain, analysts assume that 50% of MSR duration is hedged with MBS and 50% with swaps. In estimating the amount of securities that are needed to hedge MSRs, they assumed that the whole 30-year MBS agency universe has 50 basis points of servicing outstanding. This translates into a total dollar duration of about $1.1 trillion dollars, which would need about $150 billion of current-coupon MBS and $75 billion in 10-year swaps to offset this duration, analysts said. The current amount outstanding in 30-year conventional 6.0s and 6.5s are almost $300 billion and $100 billion, respectively. Thus, the MSR hedging needs in 30-year 6.5s is about 75% of the total amount that is outstanding. However, analysts said it is not realistic that this amount of 30-year 6.5s is currently being used for MSR hedging.
To understand how MSR hedges have likely evolved, analysts examined how MSR hedgers react to rising rates. As rates increase, negative duration of the MSR decreases and the current coupon increases. Thus, there are a couple of trades executed to address these phenomena: an up-in-coupon trade or an unwinding receive fixed swap positions.
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