Given the changing MBS landscape marked by increased coupon concentration, it has become harder for investors to make money through traditional venues - such as intercoupon trades - so many have started branching out and looking at other more profitable possibilities in mortgage land.
Basis trades, as well as non-index (e.g. relocation pools, prepay penalty pools, and ARMs) and specified pools will gain ground going forward, said a recent report by Goldman Sachs. The firm added that this is reinforced by the sector's year-to-date performance.
"Increasingly, investors are moving away from intercoupon swaps as the main engine for outperformance, and are instead looking toward basis trades and out-of-index sectors for ways to make money," wrote Matthew Jozoff, an analyst at Goldman in a recent report. "Although profitable intercoupon opportunities do present themselves from time to time, we agree that non-index securities and intersector trades are likely to provide the greatest profits over the next year."
Goodbye to intercoupon trading
The movement away from intercoupon trades becomes logical because of two factors.
According to Goldman, intercoupon volatility has dropped over the past five years. This is illustrated by the fact that average weekly fluctuation in the 15- to 30-year relationship has averaged only two ticks in recent times. However, it was twice as volatile in 1995, making it easier for investors to take profit.
Jozoff explained that a lot of the stability is caused by dealers who are using mortgages to hedge their risk, having the effect of linking the performance of these two sectors together. An example of this would be CMO desks selling 15-year collateral to hedge their risk.
"This tends to link the performance of 15 years with CMOS, which are really nothing more than tranched out 30-years," said Jozoff. "Basically, by linking these two sectors you end up getting more stability between the 15-year and 30-year market. The more dealers start hedging with mortgages, the more stability you are going to see in the mortgage market."
The other factor making intramortgage trading difficult is the coupon concentration in MBS or the consolidation in the mortgage index.
Goldman said that in 1995, the top 30-year coupon comprised 15% of the total mortgage index. Currently, the 30-year 6.5 coupon makes up more than 30% of the market.
The report stated that this would mean fewer real coupons that could be traded in size. Moreover, this would also imply that fewer coupons can be shorted "without concern that the coupon will become very technical."
Jozoff said that there are times, however, when a particular coupon can get very expensive. But this would generally mean that there is not much liquidity in that coupon. So even if portfolio managers could short that coupon they probably would not want to.
Coupon concentration would have implications for large investors who need to execute large trades to have an impact on the performance of their portfolios.
"The market has become concentrated on a couple coupons, and if you are a large investor it's hard for you to play to make a significant impact on your performance outside of those coupons," said Jozoff. "This is forcing investors to branch out and think about new ideas. The more consolidation there is, the harder it is to make money trading the old fashioned way."
Because of the problem of coupon consolidation, the firm suggested that large investors should start looking outside of 6s and 6.5s, and look at other ways to make a profit in the mortgage sector.
The firm gave various avenues for buysiders to take. Analysts suggested that investors continue to overweight mortgages as the carry of the sector remains too powerful. They also recommended that investors trade hybrids versus short duration mortgages, especially because hybrids are expected to become an important trading opportunity later this year.
Goldman also likes going into cheap non-index and specified pools, examples of which are relocation pools and short WALA premiums or more seasoned premiums. The firm said that CMBS would provide a good alternative to CMOs and current coupon and discount MBS.