With 3/1 hybrid ARMs currently rich to their longer-dated counterparts, investors would gain from extending into 5/1 or 7/1 hybrid ARMs, said a recent report from researchers at UBSWarburg.

UBSWarburg's report demonstrates that the yield pickup derived from an extension play in hybrid ARMs is more attractive than a comparable ride out on the yield curve in other markets such as Treasurys, Agency and Corporate debt.

For instance, in terms of Treasury data, the two-year Treasury yields 1.49% (as of close on 5/1/03) while having a duration of 1.96 years and the five-year Treasury yields 2.75% while having a duration of 4.41 years. Based on these numbers, moving from the two- to the five-year Treasury would mean a yield pickup of 126 basis points, while extending duration 2.45 years, or a yield pickup per year of duration extension of 51.4 basis points.

UBSW also looked into Agency and Corporate data and noted that in almost all categories, extending from the one- to three-year part of the curve out to the three- to seven-year part of the curve offered a pickup of 50 to 60 basis points per year of duration.

Researchers then compared this to extending in hybrid ARMs, where depending on the different pricing speeds and duration estimates, investors could be granted as much as 151 basis points per year of duration when moving from 3/1 to 5/1 hybrids, and another 217 basis points per year of duration when moving from 5/1 to 7/1 hybrids.

Underlying factors

The report added that the reason why the yield pickup is larger in hybrids compared to other product is because shorter hybrid volume outstanding has declined as a percentage of total ARM issuance. Amid this backdrop, investors are looking for extension protection - leading to a supply/demand imbalance.

Last year, 3/1 product made up 29.1% of total conventional Agency ARM supply; however, that share has been declining and dipped to 22.7% this year (figures are through April). In the meantime, the share of 5/1s has risen to 54% for the first four months of 2003 up from 51.8% last year. Also, the share of 7/1s rose sharply to 17.6% 2003 from 13.7% in 2002.

Because borrowers would rather lock in mortgage rates for the actual length of time they plan to live in the dwelling, rather than the shorter three-year term, the declining share of securitized production in 3/1s is related to the record low interest rates. Many borrowers think that within a five- or seven-year period, they will trade up to a higher-priced house.

On the other hand, investors are in a reverse position. They like the extension protection that shorter hybrids offer. The report said that while it is quite impossible to quantify, the percentage of 3/1 loans that are securitized are less than those on 5/1 and 7/1 products. Banks originating 3/1 loans usually retain them on their balance sheet; therefore, it might be that the dip seen in the relative share of 3/1 products is just a reflection of the fact that banks have been holding this product in non-securitized form.

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