Good Morning Everyone. I hope your day is going well so far. Obviously, GREEN on the MBS price board is contributing to a less stressful originating environment as rate sheet rebate is few bps better...
The FN 4.0 is +0-05 at 99-18 yielding 4.0504% and the FN 4.5 is trading +0-06 at 101-26 yielding 4.2767%. The secondary market current coupon is 4.096%.
The TSY department will auction (reopen) $20bn 10yr notes at 1pm. After falling from the 3.27% area to 3.20% early this morning, benchmark 10yr TSY yields have gone sideways ahead of the auction. The stickiness of current yield levels has resulted in RANGE BOUND price movements for "rate sheet influential" MBS coupons!
Check out the floor and ceiling we have been working with/against so far today...
In mortgage specific trading flows...fuller MBS coupons are leading the way after another slower than expected prepayment report.
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PAUSE FOR EDUCATIONAL MOMENT
Prepayment speeds determine, to a great extent, the timing of principle cash flows back to the MBS investor. If forecasts of prepayment speeds are miscalculated, the value of an MBS holder’s portfolio can be drastically affected. The faster the prepayment rate, the quicker cash flows are paid back to the bond investor, and therefore the shorter the life of the fixed income investment. Conversely, when prepay speeds slow down, the average life of the bond's cash flows are extended. This occurs because of the embedded call option in mortgage-backed securities.
Plain and Simple: Only the borrower has the option to pay off their mortgage debt. If a borrower's mortgage rate is below current market yields, they will be less likely to refinance. If an investor buys a mortgage-backed security with cash flows supported by borrowers that have mortgage rates near current market, and rates unexpectedly rise, that investor will be holding an MBS that is unlikely to prepay because borrowers will have no incentive to refinance (because current market rates are higher). This is called extension risk.
That said...because prepay speeds were once again slower than expected...and certain MBS investors are moving their positions "UP IN COUPON". They do so for a few reasons. One is to avoid EXTENSION RISK. The other is a function of greater returns.
Cash flows from coupons in the “fuller” side of the coupon stack, 5.5s and 6.0s for example, have a shorter expected life than the cash flows generated from “current” coupon 4.0 or 4.5 coupon (see reason above). MBS returns are compared to those of a benchmark with a similar expected life. Since “fuller” MBS coupons are expected to prepay before “current” production or current rate MBS coupons, the cash flows generated by 5.5 and 6.0 coupons are compared to a benchmark with a shorter maturity date. For instance one might compare the yield of a 5.5 coupon to the yield of a 5yr TSY note.
For example:
The FN 5.5 is currently +0-05 at 105-01 yielding 4.1667% (prepay speed: 18 CPR) with an average life of 4.67 years
The FN 4.5 is currently +0-06 at 101-26 yielding 4.2767% (prepay speed: 5 CPR) with an average life of 11.22 years
Since the FN 5.5's WAL is 4.67 years, returns would be compared to those of a 5yr TSY note. The 5yr TSY note is currently yielding 2.19%. The FN 5.5 is yielding 4.17%. So the FN 5.5 pays a spread of 198 basis points over the yield of its benchmark.
Since the FN 4.5's WAL is 11.22 years, returns would be compared to those of a 10yr TSY note (we use swaps but use TSYs in this example). The 10yr TSY note is currently yielding 3.20%. The FN 4.5 is currently yielding 4.28%. So the FN 4.5 pays a spread of 108 basis points over its benchmark.
Would you rather make an expected 1.98% over your benchmark or 1.08% over your benchmark????
Hopefully it makes a little more sense to you why MBS investors who chase returns (not managing duration gap) are moving UP IN COUPON today. Relative to their benchmark, fuller MBS coupons are paying greater returns compared to those that one would expect to receive when investing in current coupon/new production MBS coupons.
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NEXT EVENT: 1PM 10YR NOTE AUCTION
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