With the threat of another refinancing wave looming, investors are eyeing specified pools for prepayment protection. Investors also see the pools as a way to improve the carry for already refinancable pools.
These pools, said analysts, usually command a premium versus TBA that is less than their theoretical pay-up, because the specified pool sector is relatively less liquid.
In a recent report, Kevin Jackson, vice president and senior mortgage strategist at RBC Dain Rauscher, said that pay-ups on these types of pools have changed through time and are a product of three crucial factors: the level of interest rates, dollar rolls and supply and demand. For instance, in 1998, 30-year low loan balance (LLB) 6.5s traded at a pay-up of an average of four ticks for most of the year. Meanwhile, in 2003, the pay-up traded as high as a point versus TBAs because of historical low mortgage rates as well as attractive convexity characteristics of LLBs.
The rise in specified pay-ups have made investors recognize the value of these pools. It has also made the market more willing to pay a premium for slower prepaying MBS, said Jackson. He added that buysiders who bought slower prepaying specified pools in the early part of last year have reaped the benefits that these pools offer, such as better convexity and less refinancing sensitivity. They were also able
to improve portfolio returns considerably because of better month-over-month carry compared to non-specified MBS.
Pay-ups on specified attributes relating to certain coupons have been consistent over time. Changes in specified pool pay-ups over time were driven by increased investor interest in convex MBS collateral.
"We believe that specified pools bought at attractive pay-ups is an excellent way to improve portfolio returns and might be one of the best strategies to implement in MBS as interest rates remain at historic lows and option risk remains high," Jackson stated.
Growth in the specified pool sector has improved liquidity. LLBs are the most liquid sector in this market, Jackson said. There is now $92.5 billion in 30-year conventional LLB (with a $85,000 maximum balance) outstanding. Although this is dwarfed by the $1.52 trillion of conventional mortgage-backed outstanding with an original loan size of $85,000 or more, the growth of LLB pools still has considerably improved over the past five years.
Some trades to explore
In a recent report, Bear Stearns suggested some trades that use specified pools to protect investors from the onslaught of refinancings.
Analysts suggested new low FICO 6s. These pools have characteristics that are akin to subprime collateral such as FICOs in the low 600s and LTVs of 85 and higher. Other characteristics of these pools fall between prime and subprime - for instance, rate premiums of more than 100 basis points and modest loan balances. Bear said investors should consider these securities because of the available size as low FICO pools can be offered in blocks of $100 million or more, which is sufficient to make a considerable difference in portfolio performance.
Bear Stearns added that these bonds could prepay slowly because of their age and rate premium. A lot of the pay-ups found in specified pool collateral are derived from the fact that the paper is new (0 to 2 weighted average loan age). Aside from this, there is also a steep seasoning ramp for new paper. This is why speeds on the new paper are relatively slower in early months.
Usually, new borrowers are less likely to refinance again after just going through the process a few months before. Aside from this, these borrowers do not have much incentive to refinance now. Though they have a 7% weighted average coupon, rates have only slowed roughly 50 basis points since these borrowers took out their loan. Also, historically speaking, FICO pools prepaid slower versus comparable TBA pools in the June to August refinancing wave.
The firm is also suggesting low loan balance (LLB) 6s, which seem like the best specified pool story in the 6% coupon but they are harder to find in size, Bear said. These pools also have a longer duration compared to low FICO 6s, so they can be hit harder if rates rise sharply, but portfolios that do not need large volumes should look into LLB pools instead.
Art Frank, head of mortgage research at Nomura Securities, said that in 5.5s and 6s, it currently makes sense to trade out of fast-paying pools into select specified pools such as low loan balance, moderate loan balance and all New York State pools. In terms of Ginnie Mae premiums, Frank suggests low WALA 2003 production, in part because of the different servicer buyout rules for 2003 and later production.
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