As inflation concerns dominate price action in Treasurys, the MBS market once again faces extension risk and market participants are starting to gear up for the event. For instance, analysts from RBS Greenwich Capital believe that should 10-year Treasurys rise to the 4.65% range, extension would once again take center stage.
In its most recent report, Countrywide Securities analysts enumerated the factors currently setting the stage for extension risk, including the fixed-rate agency sector trading at a discount, as is the ARM market, rising home prices pushing the National Association of Realtors' affordability index to its worst level since 1991 and Freddie Mac's 30-year mortgage rate now exceeding 6.00%. The National Association of Realtors reported existing home prices rose to average $219,400 in August, up from $215,200 in July.
In measuring the extent of the extension problem, Countrywide analysts found that, if rates rose by another 50 basis points, the largest 30-year coupons would extend in duration by anywhere from 0.5 to 1.6. Extension would be worst in premium coupons, in which the TBA-deliverable would undergo a transition from being seasoned loans to brand-new. The firm also found that the problem would be worse if the yield curve steepened as rates were rising.
Countrywide analysts added that what sets the current environment apart from other bear markets is that "the fed funds rate is pushing hard on the heels of the 10-year Treasury with futures markets anticipating another 50 to 75 basis points of Fed tightening in the months ahead."
In the report, strategies to avoid this type of risk were outlined, including traditional solutions such as up-in-coupon trades into premiums, which in today's market mean 6s for many investors, and moving from 30-year to 15-year product.
Countrywide analysts also said that although the up-in-coupon trade should deliver strong relative performance, assuming a rate increase no greater than 30 basis points, larger rate increases, specifically in a flattening yield curve environment, exacerbate premiums' extension potential, making the up-in-coupon trade more likely to underperform. At this point, moving from 30- to 15-year paper is not the most sound strategy, because the latter is trading at very tight nominal yields, according to researchers.
Investing in seasoned pools is a strategy for a rising rate environment, analysts said, adding that the lack of TBA roll specials in lower coupons makes this trade appealing. Analysts explained that when coupons are rolling special, the opportunity cost of owning seasoned pools becomes very expensive. But in a flat yield curve environment, with supply down and CMO production limited, roll specials are usually few and far between.
"New school" strategies were also discussed, such as moving into hybrid ARMs - an option not available in previous bear markets - 20-year collateral, currently trading at much more attractive yield spread and OAS valuations versus 15-years, or GNMAs (where faster prepayments and higher payups at lower coupons make the trade attractive).
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