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

MBS: Higher Coupons Could Speed Up Later
• Refi risk in current coupon mortgages
could cause them to trade to shorter empirical
durations. Due to this factor, we maintain a
neutral outlook on mortgages.
• Higher coupon prepays could pick up over
coming months as the credit impaired nature
of such borrowers might have delayed
processing.
80%
70%
60%
50%
40%
Chart 1: Empirical Durations
4.0s Empr 4.0s Trader 4.5s Empr 4.5s Trader
5.0s Empr 5.0s Trader 5.5s Empr 5.5s Trader
30%
20%
As shown in Chart 1, mortgages had been trading to
longer durations (empirical) through June, when the
market rallied but recently these durations have
declined. As the low-yield scenario persisted in June,
the demand for incremental yield intensified, helping
mortgage spreads to tighten in the rally, leading to
longer durations. Another way of looking at this is
that, since the market trend was mostly a one-way
rally train in June and prepayments were expected to
be low, mortgages were trading with positive
convexity.
In the selloff that came after (preceding the most
recent rally), empirical durations started coming off.
Wednesday’s rally however led mortgages to widen,
continuing the declining duration trend despite a rally.
We think that for lower coupons, the refi risk,
especially in the 08 and also 09 vintages is
considerable as demonstrated in the recent prepay
report, and may be contributing to this trend; indeed,
it may have been a game changer. Note how as we
go up in coupon the empirical durations seem to be
ticking up.
We expect the continued market sentiment of a
slower economic recovery to push yields lower. This
could increase demand for incremental yield, helping
mortgage spreads to tighten. But the sceptre of
higher prepays in current coupons makes us neutral
on the basis, and we may consider selling mortgages
on strength, should they tighten considerably in a
rally.
Even after the mortgage primary rate reached
another all time low last week, the refi index actually
declined. Borrowers are clearly not getting the full
benefit of low rates. But the newer lower coupons
that define the current coupon mortgage basis as
such are callable, even though the mortgage
universe as a whole may not be all that much
callable. It is from the basis perspective that we
10%
0%
2-Apr-10 23-Apr-10 14-May-10 4-Jun-10 25-Jun-10
Source: BNP Paribas
ZV OAS
Chart 2: Current Coupon OAS and ZV OAS
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70
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60
55
50
03-May-10 24-May-10 14-Jun-10 05-Jul-10
Source: Yield Book
ZV OAS
OAS
expect 4s and 4.5s to trade to shorter durations in a
rally.
Since MBSPP proceeds are not reinvested,
increased prepays increase the net supply to the
market, which is negative for mortgages. Otherwise,
the Fed put to bed any imminent expectations of
MBS sales in its latest minutes and re-iterated that
monetary tightening will take place first before assets
sales begin. The Fed also left the door open to more
accommodative policy if the economy gets worse,
but extending mortgage purchases is only a
probability at this point. Overall, these factors also
favour a neutral outlook.
Along the coupon stack we continue to like 5 and
5.5s, which have not completely recovered from the
levels before the Fed started its coupon swap
activities. As we have mentioned in the past, the Fed
was selling rolls so as to not force dealers to deliver.
However, system-wide fails had persisted despite the
selling of rolls, and should continue despite coupon
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4
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0
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-4
OAS
Anish Lohokare/Olurotimi Ajibola 16 July 2010
Market Mover, Non-Objective Research Section
26
www.GlobalMarkets.bnpparibas.com