With the backup in rates, investors are starting to focus on issues of average life and duration risk. In a recent report, Countrywide Securities highlights the attractiveness of the PAC (Planned Amortization Class)

sector resulting from the recent move in rates.

The firm noted that as rates go up, the structural integrity of the bonds improves. In addition, a steepening of the curve following a cycle of steepening and some flattening makes the rolldown on the locked-out tranches more valuable - particularly for intermediate PACs.

PAC tranches, particularly in the intermediate part of the curve, are sensitive to volatile prepayments, wrote analysts. A period of accelerated prepays destroys the structural protection offered by the support bonds, since the supports pay off. PACs, ultimately, would have the same profile as sequential tranches. If a rate backup occurs afterwards, these newly "broken" PACs will extend, since there are no support bonds left and the PACs are no longer meeting their balance schedule. In general, the longer a transaction experiences rapid prepays, the more the structure of the PAC is compromised.

Countrywide believes PACs off 30-year 5s should most immediately benefit from the selloff. The firm analyzed a seven-year PAC backed by 30-year Gold 5s with an initial PSA band of 100% to 250% using various prepayment scenarios to see how the structure is impacted by a rapid change in the prepayment environment. The analysis showed the effective bands on the PAC after 12 months were the widest at the slowest scenario (120% to 243%). At a faster assumption of 130% of their base vector, the bands shrunk to 151% to 229% PSA. In addition, if the PAC is examined at very slow speeds, the bond's average life is shortest when run to slower initial speeds. At the slower scenario of 75% of the base vector for the first 12 months and then 125% PSA for life, the average life was 7.99 years; however, using the fastest initial scenario (corresponding to prepayment estimates for Gold 5.0s consistent with June's mortgage rates) and then slowed to 125% PSA, the bond's average life extends to 9.7 years. This supports Countrywide's contention that the structure of the PAC improves as initial speeds slow down.

The firm added that it also likes the technical situation of PACs off 5s. The slowdown in speeds will make it more difficult to produce deals off that collateral. Other sectors Countrywide sees value in includes short PACs off 5.5s, particularly for financial institutions looking for assets with good spreads over funding levels as well as limited extension risk.


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