Agency Mortgage-Backed Securities and Structured Products Market Update

General Market Outlook and Macro Environment

• Market Sentiment and Liquidity Expectations:
  • The market is approaching the July 4th holiday period, which traditionally impacts liquidity levels.
  • Liquidity is expected to be fairly constrained and "liquid" only in the sense of rapid movement rather than depth, particularly with labor data scheduled for release on Thursday.
  • Significant market volatility and movement are anticipated leading up to the holiday weekend due to the combination of economic data releases and the holiday-thinned trading environment.

Mortgage-Backed Securities (MBS) Valuation and Portfolio Strategy

• Valuation Context:

  • Current valuations are positioned at the tight end of the historical range.
  • The overall sector outlook remains neutral despite a positive fundamental backdrop for MBS.
  • Positive drivers for the sector include constrained supply and consistent board inflows.

• Trading Strategy (Charles):

  • Approach: Tactical trading with narrow directional bias.
  • Hedges: Strategies are being managed with tight hedges.
  • Positioning: Charles remains neutral, stating he does not want to be short mortgages but also avoids being overly long at current levels.
  • Rationale: The market can move quickly even on low nominal volume. Strategy is dictated by identifying significant asymmetries in risk rather than taking a firm directional view.

Specified Pools (Specs) Desk Activity

• Balance Sheet Status:

  • The desk reports zero balance sheet pressure. There are no high-level constraints at the moment, which aligns with the broader market sentiment on the Street.
  • Activity is focused on moving specific inventory rather than managing overall balance sheet capacity.

• Recent Trading Flows:

  • The previous week was relatively quiet with muted activity from "real money" accounts (institutional investors like pension funds or insurance companies).
  • "Fast money" (hedge funds) were observed selling up in coupon.
  • Desk flows included adding down-to-coupon and volatility (wall) on FICO-related paper.
  • A notable transaction involved selling "low x six" (a specific pool type) to one of Sean’s associates.

• Market Observations for Specs:

  • The $6$ role remains elevated.
  • Pay-ups (the premium paid over TBAs) have underperformed and retracted to a point where they may attract client interest despite negative carry for the upcoming month.
  • Two-sided convexity stories remain attractive, driven by geopolitical instability and the appointment of the new Fed chair.
  • Axes and Client Facilitation:
    • The desk was hit on several buy axes earlier in the week.
    • Sell axes from Jaden are expected shortly.
    • Clients are invited for social engagement (lunch, drinks, dinners) by Paul or D-Mac to facilitate relationships during the expected quiet holiday week.

Collateralized Mortgage Obligations (CMOs) and Bank Activity

• Flow and Participation:

  • Activity was dominated by hedge fund selling, primarily profit-taking on floaters (floating-rate notes) bought over the last $1 \text{ to } 2$ years that are now "in the money."
  • Dealer participation on BWICs (Bid Wanted in Competition) lists is higher than client participation. Clients are hesitant to chase levels tighter, as benchmarks were $15 \text{ to } 30 \text{ basis points}$ wider just one month ago.

• Valuation of Floating Rate Bonds:

  • Floaters are currently more accretable at tighter Discount Margins ($DM$) than previously, due to recent movements in the yield curve and the basis.
  • Bonds priced between par and a half ($100.5$) and $101$ are highlighted as offering better value than par-price bonds from new issuances.

• Fixed Rate and Bank Interest:

  • Approximately $50,000,000$ in fixed-rate bonds were moved last week (a higher volume than the desk anticipated).
  • Banks remain active buyers. Seasoned Ginnie Mae (Ginnie) $6\text{s}$ were sold as pools into a bank account.
  • Bank accounts are also reviewing floating-rate bonds and GMCs (Guaranteed Mortgage Certificates), which Avi is currently pitching.

Mortgage Derivatives (Derivs) Market Highlights

• Volume and Demand:

  • The desk experienced exceptional volume, with over $3,000,000,000$ in BWIC volume in the last week alone.
  • Trace data indicates much of this volume is trading to retail clients.
  • Levels remain well-supported despite the supply shock; no meaningful widening has occurred.

• Specific Instrument Activity:

  • Primary focus is on conventional generic Loan Balance (LB) $6$ and $6.5$ Inverse IOs (Interest-Only strips).
  • One hedge fund is liquidating seasoned $100+$ dollar IOs and Inverse IOs. These are trading well despite many being "odd lots."

• Outlook:

  • Most clients (money managers and fast money) are profit-taking and looking to net-sell ahead of the short holiday week.
  • Derivatives are expected to hold firm in the coming months due to anticipated prepayment upside.

Agency Adjustable-Rate Mortgages (ARMs) Analysis

• Spread Movements:

  • Conventional ARMs: Remained largely unchanged in terms of Option-Adjusted Spread ($OAS$).
  • Ginnie ARMs: Have widened by approximately $7 \text{ to } 10 \text{ basis points}$. Bonds previously trading at mid-$30\text{s}$ TOAS (Theoretical OAS) are now at mid-$40\text{s}$ TOAS (e.g., Ginnie Mae $5\text{s}$).

• Market Dynamics:

  • Ginnie ARMs are currently considered the cheapest sector in the ARM market.
  • The widening is attributed to two or three large banks stepping back from buying, leaving only smaller regional guys who cannot digest large blocks. This forces dealers to position themselves.
  • Yield Pick-up: ARMs currently offer a spread pick of approximately $15 \text{ basis points}$ versus fixed-rate $15\text{-year}$ products, the widest in several months.

• Issuance and Rotation Strategy (Abi):

  • June origination was light, partly due to the flattening yield curve and the cyclical nature of Ginnie issuance (which spikes every $3$ months).
  • Strategic move: Rotational trade. Sell conventional ARMs to buy Ginnie ARMs.
  • Specific Inventory:
    • An $80,000,000$ block of $7/1$ conventional ARMs at a price of $101$ is offered on the sheet.
    • A GMC (MB bond) is offered at $42y$ (spread over the curve) at a price in the high $99\text{s}$. This bond is promoted for its unique maturity profile.

Agency Commercial Mortgage-Backed Securities (CMBS)

• Supply and Performance:

  • The previous week saw over $1,000,000,000$ in secondary supply and DUS (Delegated Underwriting and Servicing) origination.
  • Performance vs. Peers: CMBS has widened while residential mortgages and credit have trended tighter. Mortgages have tightened $9 \text{ to } 12$ ticks over the last $6$ weeks.

• Investment Opportunities:

  • Low volatility ($Vol$) environment combined with widening in Agency CMBS creates a prime entry point.
  • $5\text{-year}$ bullet Agency CMBS are available in the high $30\text{s}$ OAS at par handle prices.
  • $7\text{-year}$ counterparts are expected to trade even wider; they currently sit in a "no man’s land" regarding duration for many investors.

• Inventory and Positioning:

  • The desk is utilizing balance sheet capacity to add inventory into the widening trend.
  • Available inventory includes: $4\text{-year to } 10\text{-year}$ bonds, DUS, K-series (Caves), and floaters.
  • Merchant plans to widen offers tomorrow morning to facilitate turnover and clear blocks added over the last two weeks.

Questions & Discussion

• Question (Host to Charles): "Thanks, Charles. Anything on the flow side going into quarter end month end tomorrow? Or you just wanna see normal flows?"

• Response (Charles): Clarified his tactical approach, emphasizing that he is trading with tight hedges and does not have a strong directional view. He noted he is avoiding being short or long in mortgages specifically because low nominal volume can cause quick price movements. He is waiting for a significant risk asymmetry before taking a direction.

• Question (Host to D-Mac): "Do we have any balance sheet pressure or anything on our end?"

• Response (D-Mac): Confirmed there is no balance sheet pressure. He mentioned they are only focused on moving specific inventory they want to rotate out of, rather than being limited by overall capacity. He also noted that the broader Street does not seem to be under balance sheet pressure either.

• Closing Remarks: The session concluded with a wrap-up noting the focus for tomorrow morning will be on refreshing offering levels and sending out updated options to clients in the chat.