In a report released last week, analysts from JPMorgan Securities examined the relative value of hybrids to provide and alternative to seasoned agency 5/1s. Analysts noted that bottom-up money managers are still finding cheap convexity with significant upside spread potential (due to the tail) in modestly seasoned discount agency 5/1s. For instance, analysts said that slightly seasoned 5/1s offer the same - or even better - nominal spread versus comparable coupon Dwarfs after adjusting for tail value, despite 5/1s having a shorter duration and better local convexity as a discount.
JPMorgan also said that money managers who have not been so keen to go outside of the MBS Index to pick-up value are probably going to look to the most common and liquid trade first to gain hybrid Index exposure, which is evidently seasoned agency 3/1s and 5/1s. However, analysts do not expect these to tighten much further considering their historically tight valuations. They are most likely to see nominal spread tightening in new and seasoned 7/1s. The next logical reset to benefit will be seasoned 10/1s.
The firm also thinks that there will be nominal spread tightening in the nonagency sector. As analysts said earlier, the reason is that buysiders who need to purchase in size will have to look to non-agencies as the new issue supply in agency hybrids will not be enough. Furthermore, investors can find a consistent stream of like cashflow from non-agency dealer shelves instead of trolling through multiple dealer offering sheets to find a set of securities that add up to the desired position, analysts said. The tightening is most likely to be experienced in Jumbo-A 5/1 passthroughs. But, front sequentials off 5/1s and 7/1s are likely also to benefit as well. A close second should be front sequentials off 10/1s.
Non-agency front sequentials off 7/1s and 10/1s continue to be the cheapest in hybrid space, JPMorgan analysts said. For instance, investors can pick 10 basis points or more by going into comparable coupon Jumbo-A front sequentials off 7/1s versus seasoned agency 5/1 passthroughs. This is after adjusting for the tail value in 5/1s.
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