As the year draws to a close, a big concern for MBS investors is the likelihood that strong economic data might result in rapid Fed tightening - an event not expected to bode well for the mortgage sector. In this instance, mortgages will most likely suffer from high convexity costs in a sell-off, and banks are expected to de-lever as they shed MBS.

However, some market participants do not agree with this doomsday scenario. For instance, JPMorgan Securities' macro view is for a gradual Fed tightening, more like the 1997 experience than 1994. Analysts expect that the Fed would not repeat mistakes and compromise a shaky recovery; especially given that over 1% of GDP growth has recently been attributed to the housing market. Additionally, even if rates were to increase quickly, the widening in mortgages will most likely not resemble the events of July 2003, when a significant amount of duration-related selling happened.

Mortgages will probably widen if the 10-year breaks 3.75%, a point where convexity hedging will rise sharply, said analysts. While this is a huge negative for MBS, as rolls collapse, analysts think this is highly unlikely. Rates rallying back to May-June levels would entail far worse economic data compared to what was seen at the start of the year. The supply of duration in the last five months has gone over $300 billion in 10-year equivalents - only due to recouponing and net growth in the mortgage market. In JPMorgan's view, it will require more duration demand - therefore, worse economic data - compared to that in the second quarter to get 10-year yields below 3.5%.

A long drawn-out process

Like JPMorgan, Countrywide Securities believes that the movement toward higher rates, while seeming inevitable, will most probably be a "fairly drawn-out process."

The firm said, therefore, that MBS investors should utilize strategies that will perform well in the current environment, which is characterized by a steep yield curve, a range-bound market and moderating prepayment speeds.

"It all comes down to the fact that we all think we know what's going to happen at the terminal point - rates are going to be higher and the curve will likely be flatter," said Bill Berliner, a senior vice president at Countrywide. "But there's tremendous uncertainty with respect to the timing, and the transition to a new environment won't be smooth. The key for investors is to put on positions that can perform well during that transition."

One strategy Countrywide suggests to take advantage of the yield curve's shape is to move into intermediate PACs (planned amortization classes). With the yield curve so steep right now, this is a very attractive way of reaping good returns by rolling down the curve.

Countrywide explained that a rolldown is the return - in price change - caused by the shortening of a bond's average life and duration as it ages. In an upward-sloping yield curve, bonds are benchmarked to points in the curve that have lower yields. They believe that PACs off discount collateral offer the combination of a tight principal window and extension protection necessary to successfully execute this strategy.

As the firm noted in an earlier report, "the current environment of stable to slowing prepayments and a flatter seasoning ramp is good for the structural integrity of PACs, especially in the intermediate sector." Stabilized prepayment speeds and slower ramp-up permits these securities to maintain average life and duration stability, as well as their payment window.

This would imply that buysiders who want to reallocate assets away from corporate or other bullet bonds into mortgage-backeds should buy PACs. In contrast with pass-throughs, it allows investors to gain exposure to the sector without losing the benefit of rolldown.

An investor's perspective

Overall, mortgages continue to do well as interest rates have been range-bound for the last four months, with 10-year Treasurys settling between 4.0% and 4.6%. The range has been getting tighter and tighter as the market approaches year-end. Aside from this, a declining Refinancing Index and great carry are helping the sector as well.

"The sector will continue to do well as long as we stay in the range," said Pete Perrotti, senior vice president and director of MBS at Hartford Investment Management Co.

He added that at some point, if the economic data continues to be strong, mortgage prices are likely to break the upper threshold of the range. Mortgages are bound to widen in that scenario. "We are watching that carefully," said Perrotti. "We like mortgages as long as this range holds. It gets harder close to the end of that range, when mortgages start to lag. We definitely want to keep an eye on that as an indication of when to lighten."

A week and a half prior to last week, the mortgage market was priced very bearishly, prompting Hartford to have a bias for the lower coupons. The firm still has a slight bias in the lower coupons, with 30-year 5s at the top of the list, though "we are less strong about that right now than we would have been a couple of weeks ago," said Perrotti last Wednesday. He added that carry has been improving in the higher coupons, particularly in 6s.

Perrotti explains that the mortgage market right now is priced at 101.5, which tends to be arguably one of the worst convexity points in the Index. Currently, duration is about 3.25 and 3.5, depending on the model one uses. The mortgage sector is now in the middle of that duration range. If the market rallies 50 basis points, duration can drop by 1.5 while if the market sells off 100 basis points it would probably increase to roughly 5.0.

"People are more focused on extension risk because the economy is improving and one expects rates to rise," said Perrotti. However, he feels that call risk is as much of an issue at this point. "They are both of equal risk, depending on when we break out of this range. So we're focused on both. It's really all about this range trade. If we break in either direction, the market will clearly reflect the corresponding extension or contraction."

Prepayment expectations

In terms of prepayment speeds, Art Frank, head of mortgage research at Nomura Securities International, said that most of the declines in prepayments happened in the November report. "From here we actually expect a slight bounce in December, probably a couple CPR higher in premiums, compared to November speeds," noted Frank. He said that this is because, as mortgage rates fell in mid-November, many applications that were filed during this period are going to be processed in December.

However, after the slight uptick expected for the December report, Frank predicts another marginal decline in early 2004. As the bulk of the decline from peak speeds has already taken place, he predicts prepayments are going to stabilize after the December report. "Already, this past months' speeds are not that far from what we expect long-run speeds to be at current rates," said Frank on Wednesday. "The refinancing wave pretty much terminated with the November report."

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