Given the current level of the Mortgage Bankers Association's Refinance Index - which is at its highest level in 18 months - combined with the elevated level of realized volatility (close to a 3-1/2 month high), investors should be looking for better convexity, analysts said.
In a report released recently, Deutsche Bank Securities analysts said that there are some implications for the mortgage sector arising from the combination of low rates and high refinancing volumes. One is that duration-neutral MBS portfolios will incur larger convexity-related whipsaw losses in a high realized volatility environment; and another one is that high refinance volumes suggest the fixed-rate pipeline and forward supply are building up at a robust pace.
At current mortgage rate levels, analysts expect issuance to be concentrated in the 5.5% coupon. Another thing that could affect the coupon is that, in a selloff, CMM flows along with heavy rate-lock related originator selling would hamper the coupon's performance. Additionally, 30-year 5.5%s are not quite CMO-able yet because of heavy floater inquiry and light PAC/sequential activities, analysts said.
Deutsche Bank offered several recommendations for investors, including: a long dwarf 5%/FNMA 5.5% swap or a short 30-year 5.5% butterfly. In the first trade, the supply differential is a big factor. Analysts noted that February saw nearly $27 billion in new 30-year 5.5s, while 15-year 5s saw just $1.3 billion. The firm's model suggested this swap is currently fair. In addition, the trade provides positive returns under a six-month horizon analysis assuming various parallel interest rate shifts in a +/-100 basis point range. It should be noted that the greater the magnitude of the rate shift, the higher the return on the combined position, analysts said, which illustrates the convexity advantage of the Dwarf 5s.
Another way of expressing a negative view on 5.5s is shorting the 5.5% butterfly. Deutsche analysts said that the trade is slightly negative carry, positively convex and appears fairly valued on their model. With emphasis on supply and volatility, this is a position that emphasizes positive convexity with reasonable valuation, analysts said.
In addition to the two above-mentioned trades, analysts said that the following trades also express their current view to position for better convexity: long moderately seasoned/loan balance 30-year 6s as well as agency hybrid ARMs versus 30-year fixed-rate pools.
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