FLASH UPDATE: TRV Weekly Commentary - Rate & Refi Volatility

TRV Weekly Commentary
Week Ending 19 Nov 2014

Comment:

The 10/5 spread compressed to 71 bps this week as rates bull-flattened. We attribute half of the 6 bps decline to Japan’s poor 3Q GDP print. On an annualized basis, Japan’s economy contracted 1.6%, a stark contrast to expectations, a 2.2% expansion. This data point shocked Japanese equities, with the Nikkei falling 3% . The US bond market reaction was more muted, although implied swaption vol ticked up 2 bps. We do anticipate that the unexpected contraction of the third largest economy will have had a meaningful impact on US output.

Assuming Japan’s recession has a material impact on US growth, we would expect rates to rally and spread products, such as mortgages, to lag. For now, the basis continues to outperform its Tsy hedges as down-in-coupon MBS outperformed the 5yr by 8-10 ticks. We retain a neutral to bearish view on the basis as the yield spread between the current coupon and the 5yr is 1.89 standard deviations below its mean, origination remains strong, and the Fed has finished growing its balance sheet.[1]

Notwithstanding the fall in Treasury and primary mortgage rates, the refi index fell 17 points. While this seems counterintuitive, consider that the average 30-year mortgage rate reached a low of 3.93 only one month ago. Two important mortgage concepts come into play, seasonality and the refi ‘elbow’:

§  Seasonality has a large impact on turnover in the housing market. The housing market, in terms of existing home sales, tends to pick up in the spring, reach its peak in the summer, and decline through the winter as shown in the Prepayment Seasonality chart. When a homeowner sells a house, the existing mortgage principal is paid off in full upfront, just as it happens in the case of a homeowner refinancing his loan. As we enter the winter months, prepayments will likely decrease absent a large movement in rates or a new government program.

§  The refi elbow, on the other hand, refers to the homeowner’s incentive to refi at prevailing rates. If the rate incentive were only 5 bps, we would expect minimal refi activity. However, if the rate incentive increased to 25 bps, we would expect refi activity to pick up. The Refi Elbow chart illustrates the impact of shifting the ‘elbow’ 50 basis points, thus adding 50 basis points to refi incentive. As incentive increases, we see the one-year CPR for a FNMA 3.5 TBA increase. The term ‘elbow’ comes from the shape of the curve, which loosely resembles an elbow.

Considering these concepts, it's no surprise that the refi index fell this week: seasonal impacts likely overcame the minimal shift in rates. We hope this illustration informs the reader of a portion of the anatomy of prepayments.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Prepayment Seasonality

Refi Elbow

Mortgage Basis Data

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[1] We estimate the basis as the difference between the price of Bloomberg’s MTGEFNCL Index and the yield of a generic 5yr Treasury. The data show daily spread levels between 11/21/2007 and 11/19/2014. See the chart at the end of this document for more information.

FLASH UPDATE: TRV Weekly Commentary - Impact of Duration & Convexity

TRV Weekly Commentary
Week Ending 11 Nov 2014

Comment:

Rates continue to rise following last month’s sharp rally leaving the 10yr 2 bps higher at 2.36. We’ve also seen implied volatility on the 1Mx10YR swaption declined to 69 bps. Investors’ comfort with risk assets has led the mortgage basis to continue to tighten to 139 bps –2 bps tight to our regression model, although 2bps is within the standard error of the model. We continue to expect the basis to widen, as the burden of absorbing supply will increasingly be on private investors i.e. non-Fed purchasers.

The minimal rise in rates had a small impact on the refi index as it closed down 31 points to 1590. Although we expect rates to rise in the near future, investors are pricing in higher refis as OAS on benchmark IOs continued to widen. Most notably, premium 4s and 4.5s of 2010 widened the most this week by 11 and 17 bps, respectively. If rates continue to drift upward and volatility remains low, we would expect these coupons to tighten in terms of OAS. A trade to express such a trend would be a premium/discount IOS swap.

Given a rise in rates and decrease in vol, we would expect to see spec pool payups to fall. Our expectations are generally in line with spec pool prices; loan balance decreased across the coupon stack between 1 and 4 ticks while LTV stories decreased in premium 4.5s between 2 and 12 ticks as seen in LTV>105. With rates increasing steadily, we prefer TBA versus spec for the time being.

Noteworthy:

This week, we look at convexity risk on 2010 IO trusts. Given today’s rate, spread and prepayment environment, the entire 2010 IO stack displays negative duration. The benefit to negative duration IOs is that the interest rate exposure can be hedged by purchasing TBAs – a strategy that typically exhibits positive carry. The chart below shows that a sizeable rate movement is required to bring the IOs into positive duration territory. For the time being, we foresee carry remaining positive. While negative duration is beneficial to an IO/TBA carry strategy, IOs are at their lowest point of convexity. In other words, duration is at its most sensitive position with respect to rate movements and hedging costs may increase as rates move.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

IO Duration and Convexity

FLASH UPDATE: When will the Big Fish Hit?

The fisherman carefully baits his line and casts it into the perfect spot.  He patiently waits, because he knows that big fish come by this spot regularly.  He doesn't panic, rather the wait makes him feel a certain sense of inevitability.  His decades of experience remind him that this series of actions almost always results in a big catch.   He is not concerned that no other fishermen know how prolific this hole has been.  He notices his bobber get pulled under briefly, but it pops up again...he remains patient...Again the bobber goes under, but it seems like just a nibble and it comes up to the surface...he remains patient but his anxiety starts to build...The bobber goes under for a third time, but the feel of the line is familiar this time and suddenly the reel starts to empty...FISH ON! 

We are getting multiple opportunities to add to our short high yield positions at asymmetric price levels.  Since July, volatility in the high yield market has picked up considerably, with both positive and negative swings.  This is our bobber...We are still able to short significantly challenged companies at prices above par and at or near the call price.  The opportunity is here and now.  

What is most interesting is that we have seen this many times before:  volatility picks up, sensational headlines start to draw attention, bond prices start to feel shaky and companies start to falter.  Our many years of experience make this feel like a repeated pattern of events.  The outcome is predictable, but the route to get from start to finish often provides exciting new experiences.  It is the exciting new experiences that take most stragglers and tourists out.  The yield-chasers will be burnt.  We know that we will survive those exciting new experiences, but are you prepared?   

Have a nice week,

Richard Travia

Portfolio Manager, Director of Research

FLASH UPDATE: TRV Weekly Commentary - Vol Forthcoming

TRV Weekly Commentary
Week Ending 28 Oct 2014

Comment:

As of week’s end, rates are 20 basis points lower month-over-month, although the route here was anything but gradual. The UST 10-year yield reached an intraday low of 1.87 on October 15th and has since retraced approximately 70 percent of the peak to trough distance. With the Fed officially ending its Treasury purchase program, we begin to see signs of market volatility.

In addition, future market volatility may be exacerbated by decreased dealer liquidity, particularly in spread and credit products. Much has been written on this topic as investors, financial columnists and regulators express concern regarding potential illiquidity in volatile markets. For now, this week’s lull in volatility has been beneficial for spread and credit products: premium TBAs outperformed their Treasury hedges by between 3 and 9 ticks while IOS indices tightened between 30 and 40 basis points of OAS. Despite the “risk on” mentality, we maintain a cautious view as potential headwinds may arise.

Given our viewpoints, we thought we would use this week’s commentary to examine the costs of hedging an IO as we might do in the portfolio. Going long a position in IOS FN-2003 5.5% carries at 1.5 ticks a month. Adding FN 4.5 TBA to hedge the mortgage rate and neutralize duration exposure adds 8 ticks. To offset additional curve risk we might use interest rate swaps and/or US Treasuries, costing 1 tick. And given our view on volatility, we might utilize straddles to hedge gamma and vega, consuming 2 ticks. The net result is 6.5 ticks of carry.[1]

The above illustration shows that hedging activities can have a material impact on strategies that include carry as a source of returns. Some risks may be worth hedging, while others may not be depending on your market views. Of course, the best hedge is to have no position on at all, but the opportunity cost is great.

Happy hedging,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1]  Calculations and table produced using Credit Suisse’s Locus platform