Interest rates are hitting new lows and a result, pay-ups for specified pool collateral are trading at high levels, according to Amherst Mortgage Insight.
It’s difficult to compare specified pool collateral to To-Be-Announced collateral of the same coupon because it’s a much longer duration and much less convexity, according to research from the firm.
Amherst suggested that the comparison is needed with specified pool pass-throughs to a combination of pass-throughs with a lower coupon and the addition of Treasury or swap instruments.
"Investors are concerned that, with pay-ups at very high levels, specified pool securities are vulnerable as rates rise. Our detailed empirical work shows that the best hedge for specified pools is actually mortgages with a lower coupon," the analysts stated.
For example, moderate loan balance 4.0 collateral, now has a pay-up of 4:02 while low loan balance 4.0 collateral pay-ups are even higher at 4:12.
While pay-ups may be reasonable, investors are shying away form the market because securities are too challenging to manage in a portfolio context.
With all mortgage-backed securities selling over par, TBA is worst to deliver, reflecting the Weighted Average Loan Age of the fastest cohorts.
For example, in the 4.0% coupon, the TBA has a 17 WALA, while specified poolsa re very new WALA.
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The duration of specified pool collateral is much longer than that for underlying TBA collateral. Also, the convexity of specified pool collateral is far less negative than the duration of TBA collateral, according to Amherst.
Theoretically, analysis indicated the best hedge would be a combination of the TBAs and Treasuries or swaps because it allows for a better duration and convexity match. Adding the swap however, at least in the static hedge case, failed to improve on the TBA hedges.
"The specified pool securities behave much longer than same coupon TBA counterparts, but shorter than their theoretical values. Given the empirical durations, hedging with lower coupon mortgages works quite well," the report said.
As the market becomes more bearish, the first trade for most mortgage portfolio mangers is to move up in coupon, which would result in the lower coupons underperforming their high coupon counterparts.
The higher coupon specified pools may trade longer than their empirical durations compared to the same coupon, but shorter versus lower coupon TBAs.
The Federal Reserve continues to buy large quantities in the lower coupon TBAs indicates that while the higher coupon specified pools are cheaper than lower coupon TBA securities, "the real distortion is the richness of the lower coupon TBAs."
"To meet the Fed delivery targets, the TBA bucket encompasses some loans that might have otherwise sold as specified pools with weak prepayment protection; however, there is no evidence that specified loans which provide substantial prepayment protection are being delivered into TBA pools," the report stated.