Value Commentary

OAS Risk and Market Directionality
by Alex Levin

Constant OAS pricing? Constant OAS risk measurement? Sounds convenient, but not always consistent with actual market pricing. The recent plunge in rates presents an excellent counter-example: OAS numbers surged for high-premium agency pass-throughs. Mortgage rates dropped by a good 50 basis points in the last two weeks, but OASs "absorbed" these changes as prices remained fairly constant in the premium sector. It was as if the U.S. interest rate market had nothing to do with pricing these particular agency securities.

On May 2, 2003, the constant-OAS valuation methodology suggested that the FNCL 7.5 should have 1.74 years of effective duration. This means we should expect roughly a 0.87 of a point of price appreciation for the agency security based on the observed rate plunge. The actual price change was … negative 0.04! Generally speaking, prices for coupons between 6.5 and 8.0 barely changed, reflecting market aversion to prepay-hazardous instruments. The current coupon sector actually performed well-- appreciating much more than their effective duration and convexity were suggesting.

"Price compression" is not a market anomaly. OAS carries compensation for prepayment risk - risk of prepayment surprises. A typical OAS curve plotted along the coupon axis has a form of a convex parabola. The high-premium sector demands greater OAS since it is the most volatile from a prepayment perspective. The discount sector, currently non-existent, is usually slightly elevated, compensating for possible turnover overstatement. The current coupon and adjacent "cuspy" premium sectors are usually priced richly as major prepayment fears - refinancing understatement and turnover overstatement - produce risk offsetting effects. They comprise a flat OAS plateau, for which the constant OAS method produces rather accurate results. At no surprise, the estimated current-coupon OAS exhibits historical stability.

Yet, we observe a visible spread tightening in this coupon sector. It may be caused by considerable demand by mortgage investors seeking safe harbor as well as a sign of mortgage market stabilization back to historical norms of lower OASs - traditionally, current coupons were traded much more tightly to swaps than has been seen over the last half-year. The following page shows the mortgage market's recent dynamics, for both GNSF and FNCL TBA securities. >>>