Mortgages outperformed again last week as originator selling was minimal and steady buying was seen from hedge funds, banks, money managers and CMO desks.

Over the Wednesday-to-Wednesday period, spreads tightened four to seven basis points in 30-year conventional currents and discounts, and were 10 to 12 basis points richer in 7% and 8% coupons. Fifteens also saw strong support, with spreads firming two to three basis points in 5.5s and 6s, and six to nine basis points in higher coupons.

Despite the rich levels, investors were drawn to the sector on declining volatility, attractive carry, and improving technicals. There was some concern about the GSEs' slowing retained portfolio growth; however, Fannie Mae reported an increase in April over March. In addition, the sector is seeing support from corporate crossover buying as that sector continues to be hit with negative earnings news and other headline risk.

After languishing, the 15-year sector gained fans this week on recent cheapening versus 30-year MBS. In addition, the sector saw support earlier in the week on extension risk concerns as Treasury yields backed up. While some recovery in yields has mitigated this concern, investors did add some defensive trades to their portfolios. Lehman Brothers recommended investors move up in coupon or into 15-year MBS. Another point in favor of 15s is the expected drop off in supply and increasing bank support.

Where is the originator selling? Last week, mortgage bankers brought about $500 million per day, down from $1 billion in the previous two weeks. Even those levels were below what was generally expected. With supply holding low, investors have easily absorbed the supply.

Not that there is any doubt about the increased interest in the MBS sector, but just to add hard statistics to that, JPMorgan released its MBS Client Survey last week showing a jump in the share of overweights to 40.4% from 27.9%. JPMorgan says this is the highest level since Feb. 1. The gains came at the expense of both the share of neutrals (40.4% from 49.2%) and underweights (19.2% from 23.0%).

Mortgage indexes

The Mortgage Bankers Association reported last week that mortgage applications declined for the week ending May 10. In particular, its Refi Index fell 11% to 1556, nearly wiping out the previous week's gain. In comments, Salomon Smith Barney suggests the decline is somewhat large given that mortgage rates were essentially unchanged that week. "It appears that having multiple opportunities to refinance at sub-7% mortgage rates during the past several months is depleting the pool of potential refinancers." The MBA also reported that its Purchase Index was 7% lower to a still high 357.

Freddie Mac reported that for the week ending May 17, 30-year fixed mortgage rates jumped 10 basis points to 6.89%. The 15-year fixed rate also rose 10 basis points to 6.37% while the one-year ARM gained one basis point to 4.81%. Looking ahead to next week, with rates higher, Salomon expects the Refi Index to fall another 200-250 points.

Prepayment outlook

At this juncture, extension risk fears, as well as prepayment risk fears, have faded. After rising 25 basis points since the beginning of May, the 10-year Treasury yield is down six basis points to 5.23% (as of mid-Thursday). At the same time, the increase in rates has pushed mortgage rates higher after dipping to a stone's throw of igniting refinancings on 6.5s. Looking to upcoming prepayment reports, speeds on unseasoned 6s, 6.5s and 7s are predicted to show gains of around 20% in May, while older vintages and higher coupons are expected to be little changed. The June report is looking essentially flat while July levels move back up to March/April speeds.

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