Last week's mortgage activity saw increased profit-taking following the previous week's strong tightening. Originator selling remained light with the exception of Wednesday's session that saw $3 billion. In addition, the sector was impacted by a flight-to-quality into Treasurys on terrorism attack concerns. As a result of the flight-to-quality, further supported by short covering, and rate lock unwinds, Treasury yields were back near their lows of earlier this month. In fact, the 10-year yield, as of mid-day Thursday, was down to 5.06%, off 23 basis points from a week earlier.
On the combination, mortgage spreads weakened. From Friday, May 17's close through Wednesday, spreads moved out three to four basis points in conventional 30-year currents and five to six basis points in 7% and 7.5% coupons. The 15-year sector recorded similar spread widening.
While spreads have moved out some over the past week, the sector remains rich and there appears to be "little to derail the sector at the moment," according to Greenwich Capital Markets. "MBS could remain expensive for an extended period," adds Salomon Smith Barney, and Lehman Brothers notes, "Banks and corporate crossover demand remain primary drivers of mortgage performance, with carry based trades providing the incremental support for MBS." In general, the favored sectors are 30-year 6s through 7s.
Despite the higher dollar prices in 30s, traders note that rolls have not weakened as of yet. As a result, they recommend taking advantage of the specialness early in the cycle. In the last two months, rolls have deteriorated as 48-hour approached.
Dollar roll strategy proves lucrative on historical basis
In this week's Mortgage Strategist, UBS Warburg reviews the strategy on an historical basis and concludes that "in general, over the past 10.5 years, dollar rolling has been a very powerful addition to returns." In fact, on average since 1992, "dollar rolling a portfolio of TBAs outperformed a mortgage market index by 50-60 basis points."
According to UBSW's analysis, the dollar roll strategy that offered the best dollar roll opportunity over the period was rolling only the FNMA current coupon.
Their analysis also pointed out that there were times when dollar rolling was not a good strategy. According to UBSW, the strategy "will underperform during periods in which seasoned collateral does very well versus TBAs" and "when super premium collateral outperforms current coupon collateral." Dollar rolls tend to be special during periods of heavy origination and CMO activity because originators are selling in the back months while CMO dealers are trying to close deals in the front month. In other words, such a time as now.
UBSW says it expects production to remain fairly heavy for the next few months on a combination of attractive mortgage rates and seasonals. As a result, they expect the dollar roll strategy to continue to outperform through the summer at least, and recommend investors continue to overweight dollar roll coupons that roll well.
Mortgage Indexes
The Mortgage Bankers Association announced that mortgage applications declined for the week ending May 17. This was expected given an increase in mortgage rates during that week. The Purchase Index fell 3% to 344 and the Refi Index declined 8% to 1426. Applications should be slightly higher this week as mortgage rates dipped back down.
For the week ending May 24, Freddie Mac reported that 30- and 15-year fixed mortgage rates fell. Rates were expected to be slightly higher, however, it appears that the week's flight-to-quality which lowered yields was captured in mortgage rates. Also, rates may have been impacted by some clearing out of originators' pipelines. It has been suggested that rates weren't as low as they should have been because mortgage bankers were running at full capacity.
For the record, 30-year fixed-rate mortgage rates dipped eight basis points to 6.81% and are just three basis points above the recent low on May 2.15-year fixed mortgage rates declined nine basis points to 6.28%. And last, the one-year ARM rate rose four basis points to 4.85%.
