With more clarity on the Federal Reserve's mortgage portfolio, JPMorgan Securities turned to how the market's composition will shift.

In research this week, JPMorgan analysts noted that the Fed's portfolio is more negatively convex than the rest of the market as their purchases were primarily TBA — thus receiving the cheapest-to-deliver execution — and in lower coupons. 

Analysts pointed out the Fed's portfolio of higher coupons have tended to prepay faster than the MBS universe, while lower coupons (2008 4s and 2009 3.5s) have prepaid slower. The decline to ever lower mortgage rates could cause the lower coupons in the portfolio to pick up and prepay faster, partly resulting from the average loan size tending to be higher than the market, they said.

For example, the average loan size of the Fed's holdings of 2009 4.5s and 5.5s is $50,000 higher than the market.

The combination of the Fed's portfolio paying down and new issuance will increase the composition of the mortgage index float, analysts said. As a result, they projected that over the next year, the Fed will become a minority holder of 4s, and that in two years it will probably own "only" around half the 4.5s, from nearly 80% currently.

At this time, JPMorgan analysts are estimating that the outstanding balance of the regular index weighting to increase from around 0% in 3.5s to 11% two-years out, 4s from 4% to 20%, 4.5s from 15% to 13%, 5s from 16% to 8%, and 5.5s and higher to shrink to 11% from 27%.

Meanwhile, the "free float index", or the composition of the market available to investors, will shift even more, they said. The 3.5s will increase from essentially 0% to 13% in two-years, 4s from 1% to 21%, 4.5s to hold at 7%, 5s to decline to 7% from 14%, while 5.5s and higher will total 11% from 33%.

Because 4s and 4.5s will increase as a percentage of the "free float universe", they should become more actively traded, analysts noted.

They concluded that, "net issuance could put some pressure on lower coupons in the near term, but ultimately we expect underweight money managers to cover their positions in these coupons over time as they grow in composition of the index."

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