The recent spike in discount coupon issuance and the corresponding composition shift in 30-year conventionals could significantly redefine what is TBA deliverable and dramatically alter the convexity profile of the mortgage universe, analysts said.
In a recent report, Morgan Stanley analysts noted the considerable amount of 4.5 coupons issued in August, while at the same time examining the 30-year conventional universe's evolving composition. A shift in 4.5 TBA delivery is expected - currently worth roughly 5/32 on the TBA price - and could follow for all discount coupons if mortgage rates remain stable for an extended period.
Morgan Stanley researchers report that most of the 30-year conventional supply is in 5s with $30 billion issued in August, making up roughly half of all conventional 30-year issuance. June's low rates also led to the large August production of 30-year 4.5s, equivalent to $5.5 billion between Fannie Mae and Freddie Mac, harkening back to February and March when roughly $4 billion were produced.
Analysts said that the sheer volume of issuance in August could significantly change what is TBA deliverable. At a constant OAS, the new 4.5s would be worth between 4/32 and 5/32 less than the current deliverable, analysts explained. Furthermore, the new 4.5s have similar weighted average coupons compared to the 4.5s produced in March and April, offering little pick up for the reduced seasoning. Analysts thus suggest selling TBA 4.5s in the coming weeks as the new deliverable becomes fully reflected.
Aside from what is TBA deliverable, the extended period of low rates and the predominance of 4.5 and 5 coupons could significantly alter the mortgage universe's convexity profile. Discounts currently comprise about 60% of outstanding 30-year conventionals as well as 35% of new issuance, decreasing the overall convexity of the universe and leading to a considerably lower threshold for a major refi wave, said analysts. And with most discount rolls trading at or near carry, the cheapest-to-deliver on these coupons should become significantly unattractive as new issuance is delivered, analysts noted.
Analysts also noted that the August distribution was much more spread out compared to the previous month with issuance in 4.5s and 5.5s increasing at the expense of 5s, which is attributed to the lower rolls observed over the month. The less attractive rolls gave issuers less of an incentive to artificially raise or lower the net coupon on their pools so they could sell the "hottest" rolls.
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