As international money managers are increasingly judged against global indices heavily weighted towards mortgages, Deutsche Bank Securities recently developed a total return swap that allows these investors to synthetically buy into U.S. mortgages.

The swap was designed primarily for foreign accounts that need to have some exposure to mortgages - specifically foreign investors less familiar with U.S. MBS - but who do not have the back office or administrative capabilities to handle the inflows and outflows.

This product was also developed to help investors ascend the MBS learning curve, as mortgages are traditionally considered more difficult to manage than other fixed-income securities. Aside from the fact that the back-office clearance settlement procedure is complicated, the negative convexity embedded in the sector can be challenging.

Brand-new TBA Index

Despite the inherent complexity in mortgages, this swap will make it easier for investors to move into mortgages because it is based on the new Deutsche Bank U.S. Mortgage Index that promotes pricing transparency.

The index improves transparency because it is calculated by using 30 of the most liquid MBS offered from Fannie Mae, Freddie Mac, and Ginnie Mae, according to a release from Deutsche. Additionally, the firm said that both the 30-year and fixed-coupon securities are included for the most liquid coupons.

The index tracks TBA, which is the most liquid sector of the mortgage market. Each TBA security is then weighted with the amount outstanding in the sector that it represents. For example, 2002 6.5 GNMA 30-year bonds would be weighted by adding up the outstanding mortgages in this coupon from previous production years. In this way, though the index only consists of 30 of the most liquid bonds in the MBS market, the weighting would resemble the whole market.

"The bonds included are traded very frequently; everybody knows what the price of TBA is," said Wei Wu, director in quantitative portfolio strategy.

He added that the downside for competing firms with indexes tracking older MBS is nobody really knows where these bonds should trade. Although the other firms usually give a price, those levels are merely indicative. "The advantage of this product would be simplicity and pricing transparency," he noted.

Clients want to be certain they're receiving the most accurate prices, and since this index is entirely comprised of liquid issues, the entire market can agree on the numbers. Liquid issues also give a truer picture of the current market, as they reflect the most up-to-date views of the investor community.

Deutsche said that investors could utilize the swap by paying Libor in exchange for receiving the total return calculated for the index. This would include coupon payments usually for one to six month periods. Reinvestment risk is removed because the index swap balance is held constant each month despite prepayments on the underlying collateral.

Deutsche also claims there is limited tracking error versus other mortgage-backed indices - varying only 18.5 basis points per year on average, according to a study the firm conducted.

Domestic investors

Even though the product was mainly designed for international money managers, the MBS index swap has been accepted domestically, according to Jon Zames, who will responsible for trading the swap.

Dosmestic buysiders can trade billions of dollars through the swap at a much tighter bid/offer spread compared to trading the same amount in mortgages. Thus it becomes beneficial for large U.S. money managers.

Aside from this, there are no fees involved with Deutsche serving as the swap counterparty, which could prompt pension funds to utilize the product.

The development of both the total return swap product and the new index is part of Deutsche's effort to grow its MBS business. Prior to the launch of the total return swap, the bank hired Trip Mestanas from Goldman Sachs as head of agency MBS trading (see ASR 7/15).

As previously reported by ASR, Trip reports to Jon Kinol, who oversees fixed-income derivatives. Merging the bank's fixed-income derivatives and mortgage trading desks is a unique arrangement in the MBS world. According to a release from Deutsche, this arrangement leverages the vast amount of derivative trading that mortgage investors typically require in order to hedge their portfolios.

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