FTN Financial last week took a look at relative value of 15-years versus 30-years, and recommended whole loan 10/1 hybrid ARMs as a way to take advantage of the cheapness in the 15-year sector.
Analysts started first noted that the 30-year market is four basis points cheap relative to the 15-year sector. In looking at specific coupons, they compared 30-year 6s to 15-year 5.5s, and 30-year 5.5s to 15-year 5s. This comparison reveals that
30-year coupons have traded at or above one standard deviation rich to 15-year coupons throughout 2006, but are recently in close proximity to all time highs. Meanwhile, 30-year 6s/15-year 5.5s are within 3/32 of all-time highs, and 30-year 5.5s/15-year 5s are at the all time high in FTN's models. Analysts proceeded to recommend whole loan 10/1 hyrbid ARMs as a way to take advantage of the cheapness of the 15-year sector.
With whole loan 10/1s priced off 15-year collateral, these securities are a "good means to take advantage of the relative cheapness in 15-year collateral without sacrificing a lot of carry." FTN notes that 10/1 hybrid ARMs have seen a price drop of more than a full point versus Dwarf 5.5s in the past six weeks, for essentially the same coupon (5.47% net). Other advantages of the 10/1s are approximately 30 basis point greater YTM and LOAS, while options-cost and convexity factors remain a non-issue.
In a scenario analysis, analysts point out how skewed the differential in total rate of return is between 10/1 hybrids and Dwarf 5.5s. At the base case, whole loan 10/1 holds an 11 basis point advantage over the Dwarf security, while in a rising rate environment, this advantage widens to 30 basis points over. Meanwhile, in a falling rate environment, total rate of return is only about five basis points better for the Dwarf 5.5s over WL 10/1s, making this an appealing trade for those who are expecting a pullback in the bond market.
Analysts take this scenario one step further by adding Dwarf 6s to their comparison to WL 10/1s, in order to run the trade on a duration-neutral basis. In doing this, they find that the trade is still highly favorable, with carry only slightly reduced while LOAS, convexity and options cost advantages all improve. FTN analysts point out that yield to maturity on WL 10x1 is only 10 basis points shy of 30-year 6s, with only a 2/32 roll on FNMA 30-year 6s, making this trade a "cheap way to add 15-year like performance without paying 15-year prices."
FTN analysts view their suggestion as one that is applicable to all but the "fastest money" portfolios, as there are some liquidity constraints inherent in putting on this trade. The carry and convexity advantages make WL 10/1s a worthy candidate for any portfolios with an investment horizon of a month or longer, in their view.
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