Last week analysts from Morgan Stanley recommended restoring exposure to MBS to a moderate overweight for active investors as fundamentals for MBS have become more aligned with favorable technicals. Morgan has been recommending maintaining a core overweight for long-term investors.

Morgan's mortgage strategist, Yubo Wang, commented that rates "reversing a multi-week rally, moved higher on growth/rebound expectations, reducing prepayment and convexity concerns". He added that lower MBS dollar prices added additional appeal.

Before the convergence happened, Wang noted that while risks have increased for MBS investors, compensation has not. Thus a divergence exists between fundamentals and favorable technicals.

Why the divergence?

For much of February, fundamentals in the mortgage market deteriorated as the market rallied as concerns over corporate event risk plagued the market. The rally brought mortgage rates down to 6.8% level. Lower mortgage rates have increased prepayment risk, making 43% of the mortgage market still refinanceable. The total amount of negative convexity in the mortgage market also increased. Further, the compensation that MBS investors received for selling the prepayment option has declined to historically low levels since 1998.

On the other hand, technicals in the mortgage market remain excellent. Demand is very strong, boosted by corporate cross-over buyers, CMO demand for collateral and reinvestment of portfolio run-offs.

Stay alert to

duration extension

As rates have moved higher, the fundamental backdrop has turned favorable for MBS. Before becoming more aggressive than a moderate overweight, Wang prefers to wait for still lower dollar prices and a more favorable convexity profile. Extension should be the focus of the mortgage market going forward, especially after Thursday's strong sell-off. "As our convexity hedging needs estimate, the amount of negative convexity in the market is still substantial," said Wang. Convexity concerns "are still a key consideration driving extension on sell-offs."

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