Now is an opportune time for long-duration investors to look at last cash flow collateralized mortgage obligations (CMOs) as a result of sizable selling and higher rates, analysts claim.
In general, long CMOs outperform collateral no matter what type of market they exist within — meaning this theory holds true in both a stable market and one that is rallying. While they underperform in a backup, such under performance could be mitigated as the front end may need to cheapen — and the back end to consequently richen — to maintain investor demand, according to Royal Bank of Scotland’s latest report.
“Motivated by low rates, extension protection and regulatory uncertainty, investors have generally preferred short duration paper over the past few months,” said Jeana Curro and Ashley Gam, analysts for RBS (RBS).
They added, “As a result, the neglect of last paper flows has contributed to their cheapening. Additionally, with the recent backup leaving the market potentially oversold, yields on last cash flows paper now look more attractive.”
Investors should use the traditional strategy of moving out in duration to pick up yield.
At current levels, collateral, well-structured last cash flows offer good relative value via higher yields, larger spreaders, positive convexity and improved carry, the report noted.
“We have a slight preference for long-planned amortization classes as they currently have a good combination of yield, spread and not super long durations,” the RBS analysts explained.
They added, “Moreover, in an environment plagued by rate volatility and lack of conviction, we make a case for last cash flows potential holding up in a backup as well as a rally.”
Activity and market movement during May has thus far represented a sharp contrast to prior months as longer rates reversed course and sold off significantly.
This month has resulted in stronger than expected payroll numbers due to positive economic releases and decent earnings reports contributing to record high equity prices.
More importantly, a great deal of market uncertainty on a variety of issues has impacted stronger payrolls, including the possibility of the Federal Reserve tapering its bond-buying program, a new Federal Housing Finance Agency director and a refinancing policy date change, the report noted.
As a result, investors looking for yield should dive into the recent backup, which provides good opportunities out of the curve.
“Across a variety of structures, last cash flows pick significant yield and spread to collateral and currently have positive convexity,” the analysts explained.
They concluded, “Furthermore, Long CMOs should hold up well amidst market volatility: in a rally, last cash flows will expectedly outperform shorter duration securities.”