Investors should look to purchasing 10-year fixed mortgage-backed securities paper compared to 15-year paper since 10-year paper has underperformed in an environment where they should be outperforming, analysts claim. This particular trend may create a nice entry-point for investors, the same report alleges.
The underperformance is due to lower extension risk, smaller spread duration and limited exposure to the long-end part of the yield curve, meaning investors will see better price movement, prepayment property, spread duration and yields, according to Royal Bank of Scotland’s latest report.
Looking at an example, after Ben Bernanke, chairman of the Federal Reserve, spoke on Wednesday about the possibility of the central bank tapering its purchases of mortgage-backed securities during the next few meetings, 10-year Treasury yields rose 40 basis points to 2.02%.
“In this environment of curve steepening and spread widening, 10-year paper has significantly underperformed 15-year paper despite expectations of outperformance,” said Sarah Hu and Ashley Gram, agency MBS strategists for RBS (RBS).
They added, “As a result of these price drops, we believe the cheap valuation of 10-year paper (especially in lower coupons) presents a good entry point for investors.”
One of the primary drivers for the recommendation is the belief that 10-year paper presents excellent convexity as shown by a much flatter S-curve compared with other fixed-rate products.
Thus, 10-year Treasury notes appear to offer both extension protection in a rate sell-off and hold securities in the instance of a rate rally.
“The combination of slow speeds in a steep curve and a relatively flat convexity profile should make 10-year paper appealing to investors in a market with increasing rate volatility,” the analysts explained.
Not only does 10-year paper have better convexity, but it also exhibits less spread duration.
Furthermore, the difference in spread duration is most pronounced in coupon 2% through 3%, and is much less as the coupons move up.
“The smaller spread duration implies that 10-year paper should perform well in an environment with a volatile mortgage basis,” RBS noted.
