With the recent volatility in interest rates - most apparent as the 10-year neared the 4.35% level - MBS performance has become subject to the direction of rates, said analysts. With falling rates, spreads are expected to be hit hard, while as rates rise, they will likely tighten. Currently, the market is anticipating higher rates.

"The temporary tangle between rates and mortgage performance argues for trimming mortgage portfolio exposure to volatility while minimizing any loss of carry," said Bear Stearns last Tuesday. "There are ways to that either in passthroughs, or in structure."

In terms of passthroughs, Bear Stearns had previously suggested adding volatility exposure: one way was by moving up in coupon to 30-year 6s. However, while carry in this coupon looks good, the volatility exposure appears high. So analysts suggest instead to either move down in coupon to 5s or up in coupon to 6.5s or 7s. This strategy should minimize volatility risk without giving up too much carry. Meanwhile, researchers noted that moving into 15-year paper should also limit volatility risk, although there is a significant give-up in carry.

The new 5- to 10-year PACs have recently traded at relatively higher OAS, and the structure has lower volatility exposure compared to the underlying passthrough.

"As interest rates rise, adding back exposure to volatility should make sense," said Bear Stearns. "That probably starts with the 10-year around 4.55% and reaches full speed at 4.70% or above."

Bear Stearns also noted that there is risk coming from the 30-year 5.5% moving up in price, arguing that a 40 basis points rally would make this coupon refinanceable once again.

Art Frank, head of mortgage research at Nomura Securities, said that extension risk and call risk are approximately balanced right now. He added that if 5.5s (the largest coupon outstanding) moves up in price by two points, then call risk is reintroduced to the market. However, based on the forward curve, it is more likely that this coupon moves down in price than up. Also, a 45-basis point rally is needed for 5.5s to go up in price by two points.

If there's a 50-basis points backup, extension risk would enter the market with 6s (currently priced about 102-16/32) and 6.5s. Currently, there is about $174 billion in FNMA 6s and $95 billion in Gold 6s outstanding.

Bill Chepolis, a managing director in the fixed-income group at Deutsche Asset Management, said that his bias is toward higher rates. "It's just a matter of how quickly we get there," he stated. Though most of the market is leaning toward a more aggressive tightening by the Fed, Chepolis believes that without the economic numbers picking up, the Federal Reserve might only tighten two more times before the end of the year, including a possible increase in rates on August 10.

Chepolis stated that he currently likes 5.5s and 6s, similar to other market participants who are leaning toward short-duration MBS. Only a sudden move in rates would negatively impact the MBS market, as liquidity issues come into play, Chepolis added.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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