Many investors have been moving up in coupon for quite some time given the attractive carry and muted prepayment speeds resulting from credit impairment.

At this time, FTN Financial analysts believe investors should not fight the Federal Reserve and so should start to reduce their premium exposure over the near to intermediate term given the government's aggressive program to lower mortgage rates and help borrowers refinance.

They have previously favored the 30-year 6.0/4.5 swap, which remains historically cheap. And if current conditions were normal, analysts will likely continue to like the trade, they said. But the government's involvement changes the dynamics for now and analysts think it is prudent for investors to, "take chips off the table by paring back the up-in-coupon overweight and bide time in lower coupon stories for the time being."

As an example, they highlight a synthetic discount X-PAC with a 4.5% coupon off 2005 vintage Gold 6s (FHR 3003 KP).

Analysts said that cash flow and vintage are crucial for this recommendation. The story here is that the discount coupon has less premium exposure, they said, but it is in a structure that has less extension risk than collateral. They added that the underlying collateral has prepaid slower than more recent vintages as it is loan balance paper.

In this trade, there is a 21 basis point give in yield, and nearly 28 basis points give in spread, and LOAS is essentially the same. However, it picks significantly in effective convexity (-1.95 versus -4.78). As a result, analysts said it has an asymmetrical projected total return profile assuming a six-month horizon that outperforms more in the down rate scenarios than it underperforms as rates rise.

"In other words, this is exactly the sort of profile we would recommend pursuing over the next six to nine months," they said.

For investors limited to passthroughs, FTN analysts said the only choice is to move down in coupon, but to be selective in terms of vintage to minimize extension risk. For example, 2005 Gold 30-year 4.5s and 2006 FNMA 30-year 4.5s are attractive as they are prepaying faster than surrounding vintages, analysts said.

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