The Hybrid ARM market
offers investors a diverse set of investment opportunities. Investors can
use hybrids to take advantage of a view on changes in the location of the
curve, the shape of the curve, volatility, the TED basis, and prepayments-
or to buy and sell caps and floors with various strikes. The diverse risk
exposures available within hybrid ARMS and the compound bond and option features
inherent in them make assessing their relative value more difficult, however.
This is particularly true in the current, dynamic interest rate environment.
The recent 150 basis point flattening of the yield curve is likely to reveal
numerous new and interesting performance aspects of hybrid ARMS as their origination
and prepayment behavior become better known.
To effectively take advantage of investment opportunities in the hybrid ARM
market, competent OAS analysis is critical. The results of a current OAS analysis
are presented in the table below. It reveals several interesting facts about
the risk and relative value of ARMS and Hybrids in the current environment.
|
1 YR CMT
|
3/1
|
5/1
Seasoned
|
5/1
- 2/2/6
|
5/1
- 5/2/6
|
7/1
|
10/1
|
|
| OAS Maturity |
(9)
|
34
|
18
|
42
|
33
|
20
|
23
|
| OAS Balloon |
|
(2)
|
11
|
38
|
26
|
15
|
20
|
| FC Maturity |
4
|
56
|
51
|
78
|
68
|
75
|
88
|
| FC Balloon |
|
9
|
27
|
63
|
54
|
65
|
83
|
| Eff Duration |
1.73
|
1.63
|
1.77
|
2.08
|
1.92
|
2.11
|
2.44
|
| Mod Duration |
2.80
|
2.19
|
2.26
|
2.48
|
2.33
|
2.48
|
2.42
|
| Eff Convexity |
(0.32)
|
(0.58)
|
(0.71)
|
(0.84)
|
(0.87)
|
(1.41)
|
(1.36)
|
• The duration and
convexity of 5/1 hybrids with a 2/2/6 cap structure and a 5/2/6 cap structure
are very similar. The differences in caps between these two securities do
not create material price risk differences between these ARMS in the current
environment.
• The duration and convexity of 5/1 hybrids are not substantially greater
than that of 3/1 hybrids in the current environment while the OAS difference
strongly favors the 5/1 hybrids.
• The nearby balloon inherent in the 3/1 hybrid poses increased call
risk to 3/1 investors. This can beseen by comparing the OAS to maturity and
the OAS to balloon for the ARMS.
• The OAS to maturity and balloon are very similar for the 5/1 hybrids.
This reflects the fact that the balloon payment is relatively far in the future
for the 5/1 hybrids and indicates that the tail is not the primary contributor
to the OAS of the 5/1 ARMs.