As we look at the new year, it is quite clear that the "mother of all refinancing waves" is about to start winding down. After the 30-year conventional current coupon yield hit its all-time low of 5.66% on October 31, an almost completely unanticipated bear market in November and December took the current coupon yield up to 6.74% on December 26, its highest level since mid-July, before settling down into a range of 6.45 to 6.65 in early January. This abrupt bear market in bonds caused the MBAA Refinancing Application Index to plunge from its all-time high of 5534.5 for the week ending November 9 to 1564.4 for the week ending December 21, a 71.7% drop in just six weeks! (It has since further fallen to 1284.8 during Christmas week, but that is a holiday aberration). After cheapening in early December on concerns that Japanese withholding taxes would not exempt agency MBS, GNMAs have bounced back to fair value versus convenionals when it became clear that agency MBS would be exempt. In premiums, however, we prefer GNMA IIs to both GNMA Is and conventionals, for both the cheaper prices (especially in 7.5s) and the servicer diversification that characterize GNMA II pools. We believe that the MBS market is priced slightly on the inexpensive side compared to Treasuries and agencies, and suggest a modest overweight at present spread levels. We also believe that swaption implied volatility remains quite high compared to historical averages, and is likely to decline somewhat in the first half of 2002, which would be a significant positive for the MBS market. At the present time, 15-year passthroughs are only slightly cheap to comparable 30-years, and since they do not currently roll as well, we suggest only a market weight for this market sector. If swaption volatility declines significantly from its current elevated level, and the curve flattens a bit, the 30-year sector is likely to outperform. We believe the sector to overweight is 30-year conventional current and cusp coupons (6%-7%), which have slightly higher OASs than premiums and roll better than GNMAs or 15-years. In the CMO market, we like well-structured 5, 7, and 10-year PACs backed by 30-year 6s and 6.5s, at spreads in the high 120s. In mortgage derivatives, the cheapest sector is long WAM IOs backed by 6s and 6.5s, which would benefit from a possible slowdown in the housing market and become less refinanciable if housing prices decline in a slow-growth, low-rate scenario.

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