The hybrid ARM sector looks very appealing, especially with the recent strong performance of the up-in-coupon trade, Street analysts say.
Before their inclusion in the Lehman Brothers Aggregate Index on April 1, hybrid ARMs had tightened on index demand, Deutsche Bank Securities analysts said in a recent report. However, these products lagged in the recent rally. Spreads are also nearing the wider levels seen in mid-March, Deutsche analysts said. Whole-loan hybrid ARM performance has also weakened recently following some tightening related to out-of-index buying by investors.
To demonstrate the current attractiveness of hybrids, the firm highlighted various trades in the agency and non-agency areas. For instance, analysts suggested buying a 5.5% 5/1 agency versus a duration-matched combination of 30-year passthroughs that results in a coupon of 6.22%. They said that this trade offers a substantial OAS pickup of 38 basis points and much better convexity. Analysts also consider a 5/1 hybrid agency with a 6% coupon versus a TBA combination. There is also a substantial OAS pickup of 35 basis points from this trade, though the convexity advantage is smaller at 0.2.
Looking at the whole-loan sector, Deutsche analysts suggested buying a WL 5/1 with a 5.5% coupon versus selling a TBA combo. The OAS pickup is considerable at 58 basis points with a convexity advantage of 1.9 on the hybrid. This extends as well to a WL hybrid with a 6% coupon.
The firm also highlighted a trade versus dwarfs. One example presented is buying an agency 5/1 hybrid with a 5.5% coupon versus selling a dwarf combo. The OAS pickup is 30 basis points and the convexity advantage is 0.5. According to analysts, the trade also is attractive in whole-loan space. They noted that hybrids have an attractive total rate of return advantage versus the dwarfs assuming a six-month horizon using a plus or minus 75 basis point shift both in bear and bull steepening scenarios.
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