As Street research analysts have been highlighting recently, interest and activity in the hybrid ARM sector has been picking up since Lehman Brothers indicated it would be including its Hybrid ARM Index into the MBS Index on April 1, 2007.
In a report released last week, Lehman analysts reviewed potential trades with the new benchmark, potential returns from those trades, as well as any rich/cheap indicators that could help investors time their trades in order to increase the odds of outperforming the new index.
Hybrid ARMs will account for around 11% of the MBS Index when they are included next April. At current market values, the index would increase to $3.3 trillion from $3.0 trillion.
Lehman analysts noted that the biggest impact of the inclusion will be on duration as the current option adjusted duration (OAD) of the Hybrid ARM index is 1.86-years. The effect on the MBS Index is a shortening of OAD to 3.61-years from 3.79-years. Within hybrids, 5/1s make up the largest percent at 6.2%, followed by 7/1s at 1.8%, and 3/1s at 0.9%.
Cross sector trades
Lehman Brothers analysts listed the most common relative value trades in the report. Specifically, Lehman's analysis was on the cross sector trades; the coupon swap under intra-hybrid; and on the non-agency 5/1s versus agency 5/1s in the out of index category.
Lehman notes that previously, the potential for outsized returns had been high, largely due to the volatility in the relationship between hybrids and fixed rates. Given that liquidity of hybrids has been increasing in recent years and spreads have tightened, Lehman analysts do not expect returns from the hybrid basis to be as substantial going forward. As a result, they suggested that investors look at intra-hybrid and out-of-index trades, "which have historically demonstrated promising volatility of returns" of around 40 to 50 basis points.
Looking at rich/cheap indicators, Lehman's analysts found that the best indicator is OAS spreads, which has had a good track record over the past two years. Analysts quantified the "optimal point of entry" into a trade is between z-scores of 0.75 and 1.25 for most trades, which represents deviations of three to four basis points in OAS from the mean of a relative value indicator. Analysts added that in most cases in their analysis, the optimal threshold for closing a trade was when the z-scores returned to zero. They also recommended that investors not close out a trade that has moved against them, unless the fundamentals have changed unexpectedly. Lehman analysts also stated that relative value metrics are naturally mean-reverting, and so spreads should correct.
Lehman concluded their report by mentioning areas they believe offer attractive relative value. These include trades such as 5/1s versus FNMA 6.5s and 5/1s + 10-year swaps versus FNMA 5.5s. In addition to relative value, analysts expect technicals to be favorable with low supply and increased demand resulting from inclusion of the sector into the MBS Index.
Analysts also highlighted the trade of penalty versus non-penalty loans. They noted that pay-ups are currently a fraction of their fair value. Lehman also expressed their dislike for the non-agency hybrids versus agency hybrids trade. They don't like this trade currently, partly because they see inclusion of the agency sector as a positive technical.
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