There is relative value in the 15-year sector versus 30-year MBS, said FTN Financial analysts in a report that examined 15-year performance under different market scenarios.
In the bond market rally of the past six weeks, 30-year MBS has outperformed 15-year paper by as much as 6/32s, analysts said. And despite some profit taking seen more recently, 15-year paper remains cheap by about four basis points, according to the firm's models. Analysts noted that 15-year paper is cheap to 30s across the coupon stack, but the current coupon swap (30-year 6s/15-year 5.5s) is rich by 10/32. Meanwhile, OAS analysis is also used to compare 30s to 15s, and after lagging 15-year paper through late last year and early this year, 30-year 6s have pushed tighter and remained tighter compared to 15-year 5.5s with a more noticeable divergence in LOAS since mid-July.
A complex trade
Although 15-year paper appears cheap by both of these metrics, FTN analysts admitted that the yield give-up in buying 15-year paper versus 30-year MBS makes the trade a bit more complicated, and dependent on a number of conditional elements.
In the report, analysts investigated the major differentiating factors between 15 and 30-year MBS, and showed the market environments in which 15-year MBS can be expected to outperform.
Analysts started by laying out the key differences in 15 and 30-year passthroughs - by comparing Dwarf 5.5s to 30-year FNMA 6s. One of the most obvious differences is the 40 basis point yield differential between the two securities, although the analysis also noted the heightened sensitivity to volatility inherent in 30-year MBS, as well as the greater negative convexity of 30-year product. Analysts also broke down partial duration and pointed out the greater front and intermediate partial duration of the 15-year paper versus longer partial duration in 30s.
The report also explored the carry/convexity trade-off between both securities, as analysts tried to find out at which points the added convexity of the 15-year MBS overrides the 40 basis point yield advantage in 30-year paper. Holding volatility and spreads constant, analysts tested parallel yield curve shifts (over a six month horizon) and found that in moving rates no more than approximately 50 basis points, the carry advantage of the 30-year outweighed the convexity benefit in 15s. Yield curve shifts of more than 50 basis points in either direction tilted the advantage to 15s, however, but this did not take curve shape, volatility and spreads into consideration.
FTN analysts looked specifically at changes in yield curve shape and differences in partial duration profiles. They described how a bull-flattening trade sharply shortens the average life of 30-year pools, and they also showed how the Dwarf 5.5 outperforms in most yield curve twist scenarios.
Other than the base case, the only scenario where 15s underperform 30s is in a bear flattener. Volatility was the next factor to be explored, and analysts were quick to point out that after years of declining volatility, a bounce from these historic lows is more likely than a continued decline. A scenario analysis was run for volatility as well, and the results showed that a fairly modest rise in volatility led to strong outperformance of the 15-year spot versus 30s, which should not have been surprising given the difference in volatility duration outlined earlier in their research.
The OAS factor
Another piece of their analysis was a breakdown of how much relative OAS must change in order for total rate of return for 15s and 30s to become equal under a number of parallel shift scenarios. For 15s to break even with 30-year MBS performance, spread widening of just under five basis points would have to occur under both base cases and in negative 10 basis point shift scenarios. As mentioned, a reversion back to fair value of the historical relationship of 15s and 30s would bring a four basis point tightening of spread serving to closely align 15-year and 30-year performance.
Analysts concluded that the positive results in a variety of scenarios make the sale of 30-year paper in favor of 15-year MBS a viable trade. The break even for the 15/30 swap of about 50 basis points is fairly modest, and should be reached.
They also recommended seasoned 15-year pools over TBA paper. The rationale to this trade is seasoning "offers investors an opportunity to pick up OAS and convexity and lower volatility duration with relatively minor yield concession," analysts wrote.
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