With refinancing activity expected to peak in the fourth quarter, the decline in Ginnie Mae MBS is likely to accelerate, further exacerbating the supply/demand "imbalance" in the sector, said analysts from JPMorgan Securities in a recent report.

The report stated that year-to-date, this supply/demand imbalance has reached well over $34 billion (not including overseas purchases). Over the same period, analysts noted that there was a $22 billion net decline in outstanding GNMA securities because of refinancings from FHA to conventional loans. Most of the decline was from the GNMA I program, while the outstanding amount of GNMA IIs has remained steady. With heavy paydowns expected in the fourth quarter due to the current refinancing boom, monthly outflows from GNMA securities will exceed inflows - accelerating and intensifying the pace of decline in the GNMA sector.

Analysts said that inflows to taxable bond funds remain on the rise, while the GNMA market is expected to decline rapidly in the near term. They predict the GNMA I sector to dip by at least $3 billion to $4 billion per month, while inflows to GNMA funds are estimated at $2 billion per month.

Researchers said that year-to-date, GNMA funds had net inflows of $12 billion to $13 billion. They noted that inflows to taxable bond funds have gone beyond $96 billion, half of which went to government funds investing in mortgages. Some of these government funds may have conventional MBS. The analysts estimated that a quarter of the money was put in GNMA funds.However, despite expecting the GNMA supply/demand imbalance to last through the end of the year or longer, researchers said this does not imply that GNMAs would continue to outperform conventionals. According to analysts, there should be a price point at which mutual fund inflows will be diverted to other sectors or institutional investors may start taking profits. Assuming, they said, that institutional investors would not hold GNMAs if the OAS is comparable Treasurys, then current coupon GNMA/FNMA swaps may trade north of 2 points.

"We do not expect that such lofty levels will be reached unless liquidity improves significantly in GNMAs," said analysts from the firm. They added that it is important to note that GNMA rolls have most recently been stronger than conventionals - a reversal from most of last year. This is partly a result of restrictions on GNMA funds that have to maintain at least 80% of assets in the sector. Rolling GNMAs dilutes the weighting by 50% (this is calculated as a long cash position plus a long forward position in GNMAs).

Analysts are still modestly positive on the sector, despite the fact that GNMAs are currently trading near their historical tights versus conventionals (this is adjusting for the level of swap spreads). However, researchers said that they would review this recommendation if the current coupon swaps get to over one point. They continue to like GNMA II 5.5s and 6s, and suggest down-in coupon trades in GNMAs.

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