With the recent sell-off, MBS players are now looking seriously at extension risk and trying to see where investors could find a safe haven given the coupon concentration that has lately been a hallmark of the changing MBS landscape.
Despite extension fears, however, some market participants say this is not a major concern yet, but rather something to keep an eye on. Last week's continued strong performance of mortgages seems to exemplify this notion.
Further, analysts say that most mortgages are still at par with premiums despite the sell-off - which was somewhat good for the mortgage market as it has taken the market a little bit away from the precipice of refinancing and has put it more in decent carry position.
"Obviously extension is a directional view," said David Montano, director of mortgage research at Credit Suisse First Boston. "I am not overly concerned, mostly because declining volatility should to a large extent offset the impact of extension; mortgages should do just fine as long as they are hedged appropriately vs. the curve."
Given the price of the mortgage index, there is still greater call risk than extension, without having any directional views on rates. Extension is not yet a threat in terms of spread widening and even in terms of the option costs for the index, because prepayment risk declines in a sell-off.
Montano said that extension would not really be a concern unless the market sells off by about 150 basis points, and not just 25 or 50 basis points. Mortgage spreads may tighten versus swaps in the sell-off and possibly languish once the market settles at a higher yield (lower spread) level.
Coupon concentration
With the 6%, 6.5% and 7% MBS coupons currently comprising the lion's share of bonds outstanding - while 7.5s and 8s "become pretty sparse" and pay down analysts say that it will be harder to avoid extension risk in the mortgage market, specifically for investors who have a duration target.
According to a recent UBS Warburg report, there are two "traditional prescriptions" to avoid extension risk. These are moving up in coupon and moving into 15-year balloon collateral.
However, analysts note, "the altered mortgage landscape has made both of those traditional safeties all the more difficult."
According to UBS, successive refinancing booms have lowered the average outstanding coupons, creating a distribution bias towards lower coupons. For example, UBS said that in Dec. of 1997 7.5s and above made up 58.1% of the 30-year universe. On the other hand, currently higher coupon mortgage loans only make up 18% of the 30-year sector, with the ratio diminishing each passing month.
With the imminent scarcity of higher coupons, it becomes logical for investors to go into 15-year and balloon collateral, the other traditional escape from extension risk.
Morgan Stanley notes that by moving into 15-years, "investors are able to reduce their duration exposure while maintaining the original proceeds overweight in mortgages."
However, according to Morgan Stanley analysts, even though net issuance in the 15-year sector has been more than the 30-year sector in the past two months and the size of the 15-year sector has been rising, "the expected decline in paydowns over the long run tend to mitigate these technicals."
Further, UBS adds that there is also a smaller number of loans to work with compared to previous years. Fifteen-year and balloon collateral now make up only 18% of the mortgage universe, compared to 30% in 1994.
Escape routes
With the changing MBS environment, MBS players are now looking into other avenues to hedge extension.
Art Frank, director of mortgage research at Nomura Securities International, Inc. said that extension is not so much an issue for investors who are benchmarked against the Salomon Smith Barney or Lehman Brothers indices, as these indices lengthen along with the investors' portfolios.
However, for those "who have a duration target, they may have to sell some mortgages or go into other products," he said.
Frank stated that investors could sell pass-throughs to buy short CMOs or sell futures contracts as well as use the derivatives market to lower their duration.
Other analysts said that this type of risk might be more of an issue for banks because much of their position is not duration-hedged. However, they also said banks have not been very active in the last few weeks so in a major sell-off banks might just come in and buy higher-yielding bonds.
Some market players, especially banks, are leaning towards 5/1 hybrid ARMs to protect against the risk of extension.
"These hybrid products offer better protection against extension risk because with these products, the coupon floats after five years, so you are not locking the borrower into a fixed coupon for 15 to 30 years," said Andrew Davidson, president of Andrew Davidson & Co.
