With rising rates, investors should pay close attention to cap risk, as embedded caps will significantly impact relative value in the hybrid ARM market going forward, said analysts last week.

In a recent report by Credit Suisse First Boston, they said that cap risk - especially for those investors who saw the repricing of CMO floaters and ARMs in 1994 - could serve as a major driver of valuations of securities that would otherwise trade to relatively short durations.

"Investors should now be aware of the cap risk and be sensitive to it," said Satish Mansukhani, head of mortgage research at CSFB. "We think this is especially true for instruments in the mortgage market that are short caps like hybrid ARMs and CMO floaters. It is a concern and will impact securities valuation going forward. Investors should be made aware because, if they are not, then they will be exposed to pain later on."

In terms of MBS floating-rate product, this risk is exacerbated by extension of collateral cashflows that magnify cap valuations. CSFB said that the market has placed this risk "upfront and center." In response, the firm did relative value analysis on short-reset 3/1 and 5/1 Agency and jumbo hybrids relative to callable and non-callable Agency debt and short PACs. Based on the analysis, CSFB now favors Agency debt over Agency 3/1 hybrids, Agency 5/1 hybrids over short PACs, Agency 5/1 hybrids with 5/2/5 caps over Agency debt and Jumbo 5/1 hybrids (with 2/2/5 caps).

CSFB said that in benchmarking implied forward rates today versus historical peak index levels back in 1994 to 2000, there is significant room before indexes actually reach these peaks. So despite the risk of the caps getting hit being relatively low, the potential effect on valuations had led analysts to suggest investors consider cap risk now rather than suffer the consequences later.

Meanwhile, Morgan Stanley wrote a report on the value in capped hybrids. The more stringent cap structures, like 5/1s with a 2/2/5 cap provide value relative to 5/2/5s, the firm said, though realizing this value is difficult.

The option cost on 5/1s, both standard and low caps, has risen between early April and early May. This is because the caps were more in the money. While in April the standard 5/1s and low-cap 5/1s were at similar OASs, the spread between the two is now at a wide of about 18 basis points. To Morgan Stanley, it seems there is no substantial difference between the option cost on the low cap 5/1s and on the standard 5/1s. It should be noted that option cost measures how much the future volatility in interest rates factors into the value of the cap; option cost does not measure the value of the cap by itself. In fact, the low-cap 5/1 is already in the money along the forward curve. Because of this, the zero-volatility OAS already captures a large part of the cost of the cap. The firm said that the OAS model finds the low-cap 5/1s attractive because the cap cost has more of a potential to rise on the 5/2/5s compared with the 2/2/5s, since the latter is already in the money, researchers stated.

From a fundamental valuation perspective, the low-cap 5/1s seem attractive, analysts said. To fully realize the OAS pickup on these bonds, one needs to hedge out the cap risk. A well-structured cap should do a good job of hedging the cap risk on a hybrid with less residual risk. But there are two risks in this position that lessens the attractiveness in the short term. The first is that the value of low-cap hybrids might stay depressed, with a lot of investors wanting to avoid coupon caps. Another is that a well-structured cap bought as a hedge may be expensive to get out of, which hinders the potential profits in the short run.

In the recent sell-off, Treasury Z- spreads on hybrids have widened notably and those hybrids that have the lowest caps have widened even more. Morgan Stanley said that despite their Z-spreads widening, hybrids have generally richened on an OAS basis. This richening is mainly due to swap spreads widening more compared to hybrid spreads.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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