With the Fed on a tightening trend, analysts said that investors have to prepare mortgage valuations for the impact of the curve reshaping.
In a recent report, Lehman Brothers analysts wrote, "one of the biggest developments in the bond markets has been the recent dramatic curve flattening." Analysts noted that in the past eight months the two- to 10-year Treasury slope has flattened by roughly 150 basis points and has broken through 100 basis points for the first time in recent history. Aside from this, curve volatility has also risen.
"With the Fed tightening cycle far from over, it is reasonable to expect this trend of higher volatility to persist over the coming months," said analysts. "At the risk of stating the obvious, mortgage investors need to worry about the implications of curve reshaping on typical mortgage valuations."
In the report, Lehman examined trades that have marked curve exposure, such as 30-year versus 15-year, up-in-coupon, and IO trades. Researchers concluded that the curve has already been priced into these trades. Lehman emphasized the need to hedge out the curve exposure in typical mortgage trades, especially in light of the increased market volatility as well as "fairly aggressive" pricing in of the curve in the mortgage market.
Mahesh Swaminathan, mortgage strategist at Credit Suisse First Boston, said that the yield curve flattening affects MBS in two different ways. First, it adds to the cost of hedging due to increasing partial duration weights at the front and belly of the curve and the higher cost of being short the front end. This flattening also increases the cost of funding for levered investors.
However, even with the significantly flatter curve, Swaminathan said that the current overall duration hedged carry is still comparable to January 2004, despite increased costs. In discount and current coupons such as 30-year 5s and 5.5s, the added curve hedging cost from flattening has been offset by lower overall durations today compared to January 2004.
Thus, cash investors such as foreign buyers and, to a certain extent, banks are expected to remain in the sector and could still take advantage of the carry trade. However, the constituency that might suffer is the funded investor, as their cost of funding has gone up to 2.5% based on one-month Libor compared to 1.1% the same time last year. This translates to a per month cost increase of approximately 6.7 ticks from three ticks.
"The funded investor is less able to monetize the carry play today, so they have to be more rapid fire and data driven in their trading," Swaminathan said. "However, carry still remains positive for the cash investor, so they could pursue mortgages as a carry story."
Current mortgage performance seemed to echo these analysts' views. Last Thursday, RBS Greenwich Capital released a report stating that the mortgage market continued to "chug along" despite having another week of yield curve flattening. Despite noting that 30-year product was performing better versus 15-year securities with the reshaping, analysts said that the overall MBS sector has been outperforming Treasurys. Even though further flattening could potentially push leveraged investors out of the carry trade, thus leaving the sector at risk, RBS Greenwich said that the current declining/low volatility environment would allow for enough investor participation and limit potential cheapening.
"MBS continues in the "steady as she goes" mode, with yield curve flattening not proving much of a hurdle (especially to lower coupons) as volatility continues on its downward path," analysts wrote.
Bill Chepolis, a managing director in the fixed-income group at Deutsche Asset Management, said that at the end of 2004, although mortgages remained rich, buysiders "wiped the slate and took out a new performance calculator." Many investors looked at different trade alternatives and one of them was banking on the yield curve flattener. Right now, Chepolis said - with the Fed not on an aggressive tightening mode and inflation under control - investors have shown a preference for extending out in the curve by adding 30-year collateral and lower coupon mortgages such as 4.5s and 5s. This is a somewhat unusual choice. Chepolis said that in a rising interest rate scenario, fixed-income investors typically shorten the duration their portfolios. However, currently many expect the "flattening yield curve to dominate the rise in interest rates," he said. Furthermore, 30-year product is not prepaying as fast compared to previous experience, making the sector more attractive at this juncture.
Chepolis believes there is still value in fuller coupons and in hedging out both interest rate and curve risk with futures. He added that in a yield curve flattener, they think that it is better to be short on the mortgage basis, although Chepolis mentioned that they currently favor the 30-year sector over 15-years.
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