Industry observers have been debating whether mortgage spreads have gotten so tight that the sector has become too rich. However, despite the supposed richness of mortgages, many researchers remained favorable to the sector.

Analysts said that although the sector's historical spread levels to Treasurys, Agencies and swaps were on the tight side, the technicals remained very favorable.

"Our view is that implied volatility is likely to come down from current levels and the Treasury and swaps curve are probably going to remain steep for several months to come, both of which are a plus for mortgages," said Art Frank, head of mortgage research at Nomura Securities International, Inc., last Wednesday. "So we are in the camp of the market weighting mortgages, which despite the tight spreads, are at fair value rather than expensive."

Separately, Morgan Stanley last week recommended moving from a neutral to a slightly overweight position to capture carry, saying that the environment for mortgages had improved recently. Analysts said that mortgages would most likely benefit from three factors: a range-bound market, the rebound in GSE portfolio purchases (which was seen in Fannie Mae's April retained portfolio average growth rate of 10.7%), as well as continued bank demand. The firm noted that bank mortgage securities holdings rose to $70 billion over the past six months, and total bank holdings are currently at their highest levels.

However, the firm put in a warning note for investors to keep in mind the following short-term risks: still-high dollar prices, possible supply pressure, and rising implied volatility.

Other investors said that the sell-off pulled mortgages back from the cusp of another boom in refinancing. However, Agency commitment rates continue to be substantially below where they peaked in March and early April.

"It is going to be interest rate directional," said an investor. "If Treasurys sell off because of supply issues, if corporates stay dicey with regard to credit concerns, and if Agencys continue to have fairly low-yields, then slowing prepayments would probably make mortgages the asset class of choice."

However, he cautioned that the market is on "a knife's edge here. If rates fall a little bit more, if mortgage bankers start originating loans in the mid-6s or below the 6.5% range, I think we are going to see a pretty good potential pick-up in prepayments."

Despite these fears, however, most investors remained bullish about mortgages. This is evidenced by the results of last week's JP Morgan MBS Client Survey, which showed a jump in the share of overweights.

The 15-year preference

Despite the short-term risks still inherent in the MBS market, some money managers are choosing to go into mortgages as an alternative to corporates on the heels of recent corporate blow-ups. Analysts said that these money managers would rather deal with convexity risk rather than corporate risk (See ASR, 5/13/02, p 20).

Observers say many buysiders are now looking into shifting from the corporate sector to 15-year mortgages.

"There is the interesting potential to de-couple the trading relationship between fifteen-year and thirty-year paper," said Steve Point, a fixed-income portfolio manager at Glenmede Trust Co. He explained that buysiders are starting to look at fifteen-year mortgages more in competition with corporate paper as opposed to looking at the 15-year sector as an alternative to 30-year paper.

"I think there's another dimension, as to what extent are corporate buyers looking to cross over from corporates to 15-year paper because of the more limited duration drift on 15-year paper vs. 30-year paper," said Point.

He also noted that , aside from 15-years having less extension risk compared to its 30-year counterpart, yields on 15-year paper relative to corporates remain pretty attractive.

However, traditional mortgage players are still used to making relative value comparisons within the mortgage sector. If they are looking to overweight mortgages, they usually do so by comparing the relative value between 30-year and 15-year paper.

Aside from this, there are still a lot of corporate buyers who are looking at corporates vs. Agencys or Treasurys, and are not as adept at making the relative value comparisons between 15-year paper and corporates, or even between mortgages in general and corporates.

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