With the 5.5s and 6s currently rolling very special, there is a compelling reason to move down in coupon. In fact, several researchers on the Street last week favored the down-in-coupon trade despite the extension risk on the horizon.
Analysts from Deutsche Bank Securities said that with price appreciation appearing limited in mortgage-backed securities, they are focusing on owning mortgages for carry right now. They currently favor the lowest coupons, including 30-year 5.5s.
Paul Check, an analyst at Deutsche, expects the rate scenario to continue to be a range-bound market, in which the market is currently in the middle of that range. "This scenario, together with attractive financing, favors the lower coupon 30-year mortgages even at these levels," he noted.
He cited the fact that 30-year 5.5s are rolling more than two and half ticks over carry. Meanwhile, 6s are just under four and half ticks over carry. He added that even 6.5s are rolling at three ticks over carry, but with the higher prepayments in 6.5s the estimates are more sensitive to prepayment error.
"Basically what we are recommending right now is an underweight in MBS and the underweight is mostly in 6s and 7s," said Alec Crawford, head of MBS and Agency strategy at Deutsche.
"Though we agree that there's a lot of extension risk in the mortgage market, we also think mortgages are on the rich side right now and we are recommending underweighting higher coupons, which have lower carry," said Crawford. He explained that in the higher coupons (i.e. 7s), the high dollar price and the high prepayment speeds are effectively eroding away the value of the larger coupon.
Up-in-coupon trade is out?
Some Street analysts believe that moving up-in-coupon is a good way to protect against extension risk. UBS Warburg researchers in a recent report argue that, although this trade requires a huge carry give while investors wait for the market to sell off, it is expected to perform well if the market begins to sell off. Further, Warburg emphasizes that - according to prior experience - even before a sell-off, investors will actually begin to heavily bid up the higher coupon mortgages.
They write, "...higher coupon product will vastly outperform lower coupon 30-year product, with that outperformance expected to begin before the market begins to sell off dramatically."
Others disagree with the value in this trade. Analysts from Goldman Sachs, for instance, believe that after the tightening in higher coupons, investors should move down in coupon in 30-year collateral. They said that lower coupons are more attractive right now despite the extension risk in the mortgage market.
"It's not like the higher coupons are free from extension risk," said Mathew Jozoff, analyst at Goldman. "People think that just because they are going down in coupon means that they are bringing on greater extension risk. There are pitfalls with the higher coupons as well."
Jozoff argues that on a purely fundamental basis, high coupons have gone from having the widest Libor OASs in the stack to having the tightest. He added that the hedge-adjusted carry of lower coupons is actually significantly more appealing then that of higher coupons.
He attributed the tightening in the higher coupons to the rapidly shrinking float in these loans, predicting that about $100 billion of 6.5s will be refinancing into 5.5s over the next several months.
However, he also said that while the float is too small in the higher coupons, it is currently a bigger problem for the lower coupons. He explained that 5.5s and 6s that have repeatedly seen rolls at "fail" levels, and not the higher coupons.
He added that despite the shorter durations, there are certain higher coupons, specifically 6.5s, that are actually vulnerable to a shift in the cheapest to-deliver vintage for TBA during a sell-off.
"This is something that could hurt the performance of 6.5s in a rising rate environment," said Jozoff. So this once again proves that a sell-off may be detrimental to higher coupons as well.
He also explained that the roll market indicates that there is much more demand compared to supply out there in the lower coupons than it is in the higher coupons. There is net issuance going into the lower coupons and out of the higher coupons because of the refinancings. However, considering current market prices, the dollar rolls are much more special for lower coupons. This means that there is a significant demand in the front month, indicating available supply in the lower coupons will become a concern.
Jozoff believes that there are better ways to shorten duration than by going up in coupon. He suggests that investors purchase 5.5s and 5.5% IOs. This strategy may be used to reduce the duration of a 5.5% position as well as an alternative to owning higher coupons. Indexed investors who want to move down in coupon in 30-years can actually offset the duration by moving up in coupon in 15s.
Art Frank, head of mortgage research at Nomura Securities, points out that investors who are not concerned with extension risk might consider dollar roll accounts to move down in coupon since the rolls are very attractive for 5.5s and 6s.
However, for people who want some premium exposure, he believes specialty pools, including low loan balance pools and low-WAC brand new pools, offer substantial value over TBAs.
Frank cited the fact that coupons 6.5s and higher look relatively rich. "Premiums seem pretty fully priced to us and we don't see a lot of value in TBA premiums," he said. "We suggest that they get into specialty pools rather than the TBA market for 6.5s and higher."
