Open position at +92.5bp. Potential target at +77.5bp, stop at +102.5bp. Carry and roll down (3M) +1.3bp/month.
5-year spread vs government bonds at 2013 highs
After performing ahead of the large index extensions, longer-dated mortgage bonds have underperformed (primarily versus government bonds) significantly in recent weeks. We see several reasons for this:
- Generally wider credit spreads due to a fear of less supportive central banks, although it quickly became clear that this applies mainly to the Fed.
- Month-end supply.
- Hangover after large index extensions.
- Rise in swap rates that have helped “pull up” yields on mortgage bonds. We now think that the environment should turn more supportive for long-dated mortgage bonds. Market volatility that exploded after the Fed has at least temporarily receded, in itself a positive factor for mortgage spreads. Also, we expect scant mortgage bond supply over the summer as mortgage institutions are already prefunded far out in time and little net lending occurs over the summer. Moreover, longer-dated swap spreads now appear excessively wide and we guess that the rise in swap rates has been mostly driven by flows. We expect pricing to normalise over the coming weeks.
The 5-year spread is now at the highest level for the year. We acknowledge that supply could be a concern in the long term if lending continues to gather pace, but over the summer this should not be an issue. Thus, we recommend buying 2018 mortgage bonds versus a mix of SGB1051 and SGB1052 to minimise curve exposure. Carry amounts to around 1.3 bp/month. We also change our general assessment on mortgage bonds from a neutral to a positive stance.
Risks And Alternative Trades
One could also consider trading the 2-year and 5-year curve box relative to government bonds. Indeed, government versus mortgage spreads in the short end remain near lows despite the weak performance further out on the curve. This strategy would have the advantage of being more resilient against a rise in funding costs. However, carry is around one bp per month lower than in a 5-year spread. As we see no clear driver for a spread widening in the short end, we currently prefer to trade the 5-year spread.
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