Bank of America Merrill Lynch recommends investors remain underweight in agency mortgage-backed securities although a widening of the option adjusted spread indicates otherwise. Chris Flanagan, MBS/ABS strategist at Bank of American Securities, said the "continued bull flattening of the yield curve is the elephant in the room for agency MBS." Normally a widening of the option adjusted spread "makes the sector appear attractive," but Flanagan said this "does not account for the substantial risk that we are on the cusp of a classic Fed-induced refinancing wave, where the magnitude of the wave once again surprises the MBS market to the upside and mortgages underperform." And an early indicator of this risk is this week’s break above 4000 in the Mortgage Bankers Association’s refinancing index, according to BofAML. "Moves higher would be slower and more gradual than in the past, but we think investors should not underestimate the potential to move higher," Flanagan wrote in the firm’s MBS: Securitization Weekly Overview. Flanagan said with the Fed indicating the current ZIRP rate will remain in place for awhile, any flattening in the yield curve would require "a further, and still major, back-end rally." And "by major, we mean something on the order of at least 100-150 bps," he said. "While we can think of a few, very good reasons that this scenario might play out," Flanagan wrote. "We need to be clear that we are not making a rate call here. We are simply highlighting this as an asymmetric risk scenario for mortgages." Write to Jason Philyaw.