Extension risk has risen with the back up in mortgage rates. Thisevent could impact ROEs substantially in a further sell-off, said Deutsche Bank Securities mortgage analysts.
Additionally, the higher mortgage rates are likely to lead to the additional weakening in the housing market and, in turn, add to the slowing in speeds and further extension.
Deutsche analysts said that house prices would have to fall 8% to maintain the same monthly payment a borrower would have paid before the recent 100 basis point sell-off in mortgage rates.
They added that the Case-Shiller Home Price Index has some seasonality suggesting the recent stabilization in home price declines is not likely to be sustained as winter approaches and that is not even accounting for mortgage rate levels. Then, of course, the impact from job losses and increased prime delinquencies added more pressure to home prices.
With this outlook, analysts recommended that investors move from loan balance paper across the coupon stack and into seasoned 5s and 5.5s, believing that these coupons will hold their value in a further sell-off. They said the protection in a sell-off comes from the shorter duration of the seasoned collateral.
For investors who think that the sell-off is temporary and that a rally is likely, Deutsche analysts suggested 2004-2005 vintages, as these vintages also provide call protection.
In terms of loan balance paper, analysts said that if prepayments stay at current levels for the next couple of months, it appears that carry is quite poor given processing delays. In addition, they said the roll specialness in TBAs diminished the carry for these bonds.
Meanwhile, burnout seems very apparent in refinancing activity, so even if the market rallies again, analysts think that prepayments will remain muted. This reduces the usefulness of loan balance collateral.
When it comes to 6%s and 6.5%s, analysts noted that these coupons are likely to remain at premiums, unless rates back up 100 basis points to 150 basis points, respectively. With the prospect of weaker prepayments resulting from the housing market outlook, there is less need for call protection in these coupons.