Fixed Income Recap

Treasuries
The two-year finished the day down 1/64, and the ten-year was higher by 3/64. The benchmark curve was 2 basis points flatter on the day, and remains at +184 bps. A basis point represents .01%.

MBS
In yesterday’s recap I mentioned that “as the duration continues to creep lower on 5.5% and 6% pools, the comparison [between higher coupon and lower coupon pools] is almost becoming inappropriate.” I apologize for being so vague; let me explain what I meant a little further.

Mortgage rates currently sit at historic lows, thanks to government plan to purchase 28% of the agency MBS outstanding. LTV (Loan to Value) restrictions will be relaxed through President Obama’s “Make Home Affordable” initiative, qualifying many more “underwater” borrowers for a conventional refinance. The market considers these new variables when building consensus speeds, but opinions differ greatly and most likely err on the faster side of prepayments. These are driving valuations far from the historical norms.

Historically, prepayment speeds on higher coupon MBS are faster than lower coupon MBS. This follows the logic that when rates drop, homeowners are more likely to refinance a mortgage with a higher rate to save on interest costs, and faster prepayments on the underlying loans result in shorter average lives and durations.

The spread between the ten-year Treasury and new 30-year MBS is often quoted because historically they both have a duration of around 8 years, making it an “apples to apples” comparison. While the duration of the ten-year remains at 8.57, new issue 30-year 6% pass-throughs currently have a duration of 1.48. This is obviously no longer an “apples to apples” comparison. When the durations differ so greatly the relationship doesn’t carry the same weight, and claiming that one coupon outperforms another based simply on its change in spread over the ten-year treasury isn’t as effective.

Treasury Purchases by the Fed
The Fed purchased $6 billion in 3-4 year Treasury notes today, in line with expectations. Tomorrow the Fed will purchase notes ranging from four to six years to maturity.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst