In a recent research, Countrywide Securities explored the strategy of using the "current-carry" approach for the valuation of low-loan balance (LLB) and intermediate loan balance (ILB) pools.
This approach, unlike the option-adjusted spread calculations, seeks to measure the short-term value of the prepayment advantage of these pools versus generic average pools and TBA rolls. LLBs are loans with original balances of less than $85,000 while ILBs are loans with balances between $85,000 and $110,000.
Analysts said that they found this evaluation tool useful since many investors look at pool payups by estimating the number of months it will take to recapture the payups. Additionally, it is very useful to highlight the importance of explicit assumptions relating to the persistence of specials in TBA rolls.
Looking at current carry on LLB and ILB pools versus generics or TBA rolls would require forecasting of prepayment speeds on the generics, prepayment speeds on the LLB or ILB collateral and the degree of "specialness" that is priced into TBA rolls.
For those who roll, the degree of specialness of TBA roll levels is also a significant part of current LLB and ILB carry evaluation. Apparently, an assumption concerning the attractiveness of TBA rolls has a considerable effect on the current carry of these pools.
The sensitivity of current carry calculations to the assumptions regarding TBA roll levels is noteworthy. Researchers said that it is not an overstatement to say that a standard deviation in TBA roll level is worth several standard deviations in LLB prepayment assumption. In other words, this methodology is quite sensitive to the specialness of the roll market, which is particularly evident when considering the volatility of TBA roll levels.
Analysts noted that the recent experience of both 6.0 and 6.5 roll markets is telling. Conventional 6.5 rolls have been poorly bid of late. They are trading to fast prepay assumptions and rarely special. Also, the 6.0 roll has been the least special in times such as the beginning of March when its price reached roughly 104 and prepay expectations were on the rise.
For buysiders, deciding whether to pay up for LLB or ILB 6.0s should depend largely on whether they believe that the significant specialness in 6.0s will continue.
On the flipside of the coin, the "slow" case assumes modestly slower prepays and substantial ongoing specialness in rolls. This results in LLB appearing unattractive. In this case, investors are better off in TBAs
The firm believes that at current interest rates, roll specials on 6.0s are not sustainable. This coupon has seen a series of actors that are likely temporary, including the effects of dealer hedging of large convexity pool positions as well as lingering pressures from the near-squeeze period a few months back. This was when large bank buyers pushed 6.0 prices to unreasonable levels. At very fast speeds, analysts believe that the negative carry of shorting rich rolls will send these hedgers (and the banks) elsewhere.
In the final analysis, TBA roll specials result from technical market conditions that are unpredictable. Even when buysiders think that rolls are probably going to remain special, there are diversification and risk-management arguments to be made for moving some exposure to TBAs into LLB and ILB pools. With this said, roll specialness usually serves to temporarily cheapen LLB payups, creating opportunities for non-rolling investors to take advantage of the sector.
Researchers said that by current carry advantage of LLB and ILB pools, investors may be receiving higher yield on the product. They believe that this results in very conservative valuations for LLB and ILB. This goes against the precept that superior convexity bonds should yield less, not more at fair value. Though current carry is now useful, it ultimately reinforces the notion that LLB and ILB are undervalued asset classes.
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