The Federal Reserve's targeted buying primarily in the lower part of the coupon stack (4.5s and 5s) has made these coupons rich versus the rest of the stack, FTN Financial analysts said.

This is supported by results of the firm's coupon swap model which shows the 30-year UIC trade is cheap in 5/4.5, 5.5/5 and 6/5.5. LOAS results from Yield Book also show the richness of the lower coupons as they have tighter spreads and worse convexity.

Analysts suggest a more attractive investment alternative can be found in fixed rate CMOs where certain bonds provide picks on YTM, Libor Z-spread and LOAS as well as much better convexity.

Analysts illustrated this through two examples. The first is FNR 2007-6 PA, which is a current-pay wide-window 5.5% PAC backed by 29 WALA 10/20 IO 5.5% collateral that has a similar cash flow profile to a 30-year passthrough.

The bond picks 46 basis points year-to-month, 63.5 basis points Libor Z-spread, and 85.4 basis point LOAS versus a 50/50 combination of FNCL 4.5s and 5s. In a 12-month total rate of return analysis of 13 scenarios, the CMO has a positive return in all ranging from three basis points in "upflat" to +227 basis points in "dnflat".

Another example used FHR 3062 LE which is a locked-out tight-window 5.5% PAC backed by 42 WALA FH Gold 5.5% collateral and is attractive for investors that want more targeted curve exposure.

Versus the 50/50 combination of 4.5s and 5s, the bond picks 42 basis points in year-to-month, 73.5 basis points in Libor Z-spread, and 81.8 basis points in LOAS.

In the TRR analysis, the CMO outperforms in all the scenarios ranging from 34 basis points in "upflat" to 287 basis points in "dnstp".

CMOs are not eligible purchases under the Fed's MBS program. However, for investors who want to reduce cash flow uncertainty with higher projected returns, the market is creating an opportunity in the fixed CMO sector said analysts. 

Analysts added that the majority of CMOs in the secondary market are backed by seasoned collateral and some of them have favorable collateral attributes, which offer prepayment protection.

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