Market Economics | Interest Rate Strategy - BNP PARIBAS ...

MBS: Stay Long
• We recommend staying long the mortgage
basis. Valuations remain reasonable and the
carry in back months is attractive, fully
reflecting the slowdown in speeds.
• In a rally, servicer convexity costs keep
primary rates in check and in a sell-off
incremental extension is low. If rates remain
range bound as we expect, the curve hedged
carry (adding back convexity costs) remains
formidable in this low yield environment.
• We continue to like going up in coupon into
5s through 6s due to the attractive carry.
15s/30s appear to be on the richer side.
• Investors considering front sequentials off
CK collateral may also find value in similar
bonds off FG collateral, given that FG 4.5s are
trading 9 ticks below parity while CKs 4 ticks.
• STRATEGY: Long MBS, Long UIC.
The poor performance of mortgages on Tuesday was
partially erased on Wednesday and, week over
week, mortgages were tighter by 4-8 ticks depending
on the coupon. We continue to remain overweight on
the mortgage basis. As shown in Chart 1, the
regression of the current coupon versus rates, curve
and vol (to capture market rather than model
sensitivities to these factors) indicates that
mortgages are marginally cheap. However, we would
argue that, considering the low rate environment we
are in and the need for spread, the regression does
not reflect the overall attractiveness of the product.
Chart 1: Regression of Current Coupon versus
Rates, Curve and Vol
bp
25
20
15
10
5
-
(5)
(10)
(15)
(20)
Jan-10
Feb-10
Source: BNP Paribas, Bloomberg
Curr Cpn Rich Cheap
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Cheap
Chart 2: Mortgage Carry in Ticks
Curve and Convexity
Hedged Carry
Rich
Nov-10
Dec-10
Jan-11
Curve Hedged Carry
Cpn 1M 2M
Back Month
(2M-1M) 1M 2M
Back Month
(2M-1M)
3.5 -1.6 -2.4 -0.9 -0.7 -0.7 0.0
4 -1.3 -1.8 -0.5 1.0 2.8 1.8
4.5 -1.1 -1.0 0.1 3.0 7.3 4.3
5 -0.2 1.4 1.6 3.3 8.6 5.3
5.5 0.3 2.4 2.1 2.2 6.3 4.0
6 0.8 3.9 3.1 2.3 6.9 4.7
Source: BNP Paribas, Yield Book
Chart 3: S-Curve of the Refi Index (Refi Index
versus Freddie Mac Survey Rate)
5500
For example, consider the carry of mortgages on a 1
month and 2 month basis, both considerably
negative for lower coupons. But the carry of
mortgages is quite attractive in the back month, as
the impact of low prepays is fully reflected.
Convexity concerns in a sell-off are likely to be
muted. As we have discussed previously, when the
10y Treasury went beyond the 3.50% level, the bulk
of the convexity flows were done. We have rallied
somewhat since then but prepays haven’t picked up
materially as reflected in the refi index since primary
rates haven’t budged to levels where borrowers care.
This may be due to increased convexity hedging
costs of servicers in a rally that keeps primary rates
in check. Thus with mortgage rates sticky in a rally
and relatively low extension in a sell-off, mortgages
are poised to do well in rate moves. If rates remain
5.4
5.2
Source: Bloomberg
5
4.8
4.6
4.4
4.2
5000
4500
4000
3500
3000
2500
2000
1500
4
Anish Lohokare / Timi Ajibola 20 January 2011
Market Mover, Non-Objective Research Section
36
www.GlobalMarkets.bnpparibas.com