As Treasurys rally and as mortgage rates drop, mortgage servicers are looking to hedge their exposure against prepayment risk in the swap market. This is making swap spreads tighten relative to most other asset classes, particularly 10-year agencies.

As of Wednesday last week, 10-year agencies were only five basis points under the 10-year swap rate.

According to mortgage analysts, part of the tightening is caused by servicers wanting to buy duration in the swap market to hedge their mortgage portfolios.

Mortgage servicing, basically an unsecuritized interest-only strip, is a negative duration asset. As mortgage rates fall and prepayments speed up, the servicing runs off as people prepay their mortgages.

And currently, there is good value to be had in the swaps market relative to other hedging instruments such as principal-only strips or discount passthroughs.

"You could buy a good deal of duration at a decent spread to Treasurys in the swaps market," said Art Frank, head of MBS research at Nomura Securities. "Basically, mortgage servicers are looking to buy duration in size in a large, liquid market and their hedging activity has definitely had an impact on the swaps market."

March saw a lot of hedging activity as the market witnessed mortgage rates reach their lows. However, hedging gradually slowed as the exposure was adequately hedged. Hedging activity picked up again recently as rates began to fall. This, in effect, has brought swap spreads in.

And if the Treasury market continues to rally, swaps spreads would likely tighten further. This might cause ten-year Agencies to be on top of swaps.

"If we see a continued rally, I think the desire to buy duration in the swaps market could put those spreads on top of each other," said Frank. "That would be unprecedented if 10-year Agencies and 10-year swap yields were on top of each other."

This scenario would put agencies on top of single-A rated banks, which serve as swap counterparties.

"On fundamentals this may seem odd," said Frank. "But the fact is that the swaps market is a deep market, and you could buy a billion ten-year swaps in a hurry."

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