Lehman Brothers recently announced it would include U.S. agency hybrid ARMs as part of the MBS Index beginning April 1, 2007. As of the Sept. 28 close, the U.S. Hybrid ARM Index contained 1,285 bonds with a market value of $321 billion, analysts said. The projected share of hybrids within the MBS Index based on Sept. 28's close is 10.7%. Analysts also noted that given the shorter duration of ARM securities, the MBS Index is estimated to shorten by 0.16 years.
As a percentage of the U.S. Aggregate Index, hybrid ARMs are projected to represent 3.6% by market value. With the addition of the hybrids, the MBS Index is forecast to represent 37.3% of the U.S. Aggregate Index. In addition, Lehman analysts reported that the Aggregate Index would likely shorten by 0.10 years. Finally, analysts stated that this addition would not affect the Global Aggregate Index.
As it currently stands, around 65.2% of Lehman's Agency Hybrid Index consists of 5/1 hybrids, which are largely concentrated in the 4% to 5% coupon range. Analysts also reported that 3/1s make up 9.3%, 7/1s 18.3%, and 10/1s 7.1%, that 38% of the index is in IO loans; and that most of the production is 2004 (27%) and 2005 vintages (38%).
Potential market impact
JPMorgan Securities analysts estimate demand for hybrids from index managers could be as much as $75 billion. This is almost eight months of issuance in the agency hybrid market, they noted. Also expected to benefit are non-agency hybrids - even though they are not included in the Index. Investors who need to buy in size will need to look to the non-agency sector, as the new issue supply in agency hybrids is not enough, JPMorgan analysts said.
Meaningful portfolio adjustments to the index changes are not expected to take place until the weeks prior to the April 1 date, Merrill Lynch researchers suggested. They also are not anticipating a dramatic tightening in spreads because many investors already own ARMs as out-of-index investments and as a way to outperform the market. Still, some favorable impact on spreads is expected from those investors who currently do not own ARMs. At the same time, those investors have plenty of time to "wait and see how the market reacts before purchasing," Merrill Lynch analysts said.
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