On the heels of recent corporate blow-ups (e.g. Qwest and Worldcom), a number of money managers are flocking from corporates into mortgages. Those who have made the jump into MBS have said that they would rather deal with convexity risk than credit risk, analysts argue.
With more and more managers doing this crossover, UBS Warburg focused on the corporate-mortgage trade in a recent report. In its analysis, UBS showed that while the spreads on both sectors can be considered wide by historical standards, corporates are the relatively wider of the two. But, having said that, analysts also noted that, “corporate spreads are also as volatile as they have been at any point since 1986.”
This is why, at this juncture, and on a risk-return basis, analysts at the firm said that they favored mortgages. In the report, they examined the spread-standard deviation trade-off for mortgages and corporates. They concluded that it is actually more favorable in mortgages than corporates which indicates to them continued crossover buying by corporate players.
“Our analysis suggests that investors are insufficiently compensated in corporates for this level of volatility, and that the risk-return relationship in mortgages is more favorable,” wrote UBS. ” That is one very powerful conclusion, particularly against a backdrop in which our market feedback indicates that the average money manager is very overweighted in corporates, neutral-to slightly overweighted in mortgages, neutral-to-slightly underweighted in Agency debentures, and very underweighted in Treasuries.”
According to UBS, moving some of that corporate overweight into mortgages would not only help investors to reduce risk but it will also allow them to maintain their heavy overweight in spread product.
Using historical analysis, UBS calculated that the current 131 basis point level in corporate spreads (10-year A rated bank and finance paper) is much narrower than is suggested by the current level of volatility. It should be 150 basis points. Mortgages, meanwhile, are now at 152 basis points, much wider than 129 basis points given historical experience.
Riding on the
GNMA bandwagon
Due to recent cheapening, both Morgan Stanley and JPMorgan were on the bandwagon for Ginnie Mae MBS last week.
Morgan Stanley said that the sector has cheapened substantially versus their conventional counterparts. The cheapening is the result of increased Treasury supply expectations, swap spread tightening, the prospects of further spread tightening, and the more favorable roll market in conventionals. At this time, the firm’s analysis shows Ginnies to be fair to cheap.
The analysts also noted that with the cheapening of agency debentures, conventional MBS are likely to be negatively impacted. Morgan Stanley suggests investors overweight GNMA 6.5s or 7s, and note their recommendation is especially applicable to total return investors.
Separately, JPMorgan said that the call risk on GNMA IIs is significantly less than conventionals.. In addition, GNMAs also offer superior extension protection versus conventionals. Analysts based this view on the lower loan balances of GNMAs, combined with a strong housing market which should lead to faster GNMA discount speeds.