By Andrew Davidson, president of the Andrew Davidson & Co., Inc.

The continuing unrelenting rally has turned all mortgage investors into premium investors. In an upward sloping yield curve environment, premiums have risk and return characteristics that may appear odd to investors who are not familiar with IOs.

For this analysis, we will examine three premium Fannie Mae 30 MBS with coupons of 5.5, 6.0 and 6.5. On May 16, all three were trading with prices between 103.75 and 104.5. The idea that the price spread between 5.5s and 6.5s has been crushed from 5 points to three-quarters of a point makes the market seem somewhat unreal, yet the situation gets even more confusing when we look at static spreads and OAS.

The Fannie Mae 6.0s, in the middle of the stack, have a static spread of 25 basis points (using a Z-spread to the swap curve assuming mortgage rates remain constant). This would seem like far too little compensation for the risk of a premium MBS, as there must be some option cost. Yet taking into account option cost, the OAS of the bond still turns out to be higher than expected at 16 basis points. It would appear that the option cost is only 9 basis points. While the 6s may be beyond the cusp point, nine basis points seems woefully inadequate as an option cost.

Let's take

a closer look

In Table 1, we show various spread measures for the three bonds. In addition to the stable rate spread and the OAS, we also show the spread assuming that prepayments are driven by forward rates and illustrate the difference between the various spreads. The difference between the forward spread (which is also the zero volatility spread) and the OAS is the option cost. Note how, when measured in this way, the option cost varies from 48 basis points to 75 basis points. These option costs appear to be more in line with expectations.

Table 1 also demonstrates the difference between the stable rate spread and the forward rate spread. These two numbers are calculated the same way, except for the prepayment rate. For the stable rate (or static) spread, we assume that the mortgage current coupon remains at its current level for the life of the mortgage; for the forward rate spread, the prepayment speeds are based on forward rates. Table 2 shows the prepayment rates and yields under the two assumptions. The difference between the two spreads is the forward cost. In this case there is a benefit. The steep yield curve slows down prepayments. These bonds gain in value as the high coupon is earned for a longer time. In this way, these bonds act like IOs.

The three bonds show varying levels of benefit, with the 6s and 6.5s gaining over 50 basis points of value from so-called "hedge value." Thus, the net OAS for these bonds represents a combination of a "hedge value" and option cost.

Some of this hedge value is exhibited in the average life. For example, the Fannie Mae 6 has an average life of about 1.3, which, under forward rates, can double to 2.6 years, yet its effective duration is only 0.6 years, as shown in Table 3.

This combination of features makes these bonds somewhat difficult to value and difficult to hedge. Changes in the level and shape of the yield curve and changes in prepayment expectations can have significant impact on value and risk.

Investors who have been involved with IOs recognize these features. For those who have avoided IOs in the past, the current market is providing a startling introduction to the characteristics of the IO features imbedded in premiums.

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