TRV Weekly Commentary
Week Ending 11 Nov 2014
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
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