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A Stealthy Way to Play the Housing Slowdown

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...there is more than one way to skin a cat in this business.

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The land of fixed income, as we have expressed here before, is opaque, as opposed to the 'transparent land of equities.' Bonds, for the most part, trade in an 'over-the-counter' market, much like stocks did in years gone by in the Pink Sheets (now I am really dating myself). Outside of the derivatives market, one of the most complicated parts of the bond market is the land of mortgage backed securities.

Where am I going with this? It is now evident (despite Mr. Hovnanian's proclamation last night) that the housing market IS slowing. It is slowing in resales, inventories are building - as a result of the combination of rising rates, rising prices and the basic lack of affordability that goes with it. As the whole process slows, so does the rate at which mortgages are both refinanced and mortgage applications for new homes.

The result is a slowdown in the prepayment speeds of outstanding mortgages, and hence, mortgage backed securities (MBS). As we have noted repeatedly, we are cautious on housing. As a result, we have been accumulating high coupon, 'seasoned' MBS as it allows us to keep our higher coupons longer, hence, increasing yields. It also helps cushion our clients' portfolios against general rises in open market rates.

One thing to be careful of, is to stay away from low coupon mortgage backed securities in this scenario. If one were to own, say a 5%, 30 year GNMA pool that suddenly slowed down, its average life, or duration, would extend at the worst possible time. Rates are rising and the security is going out on the curve. This exacerbates the loss and is a sure-fire way to magnify your loss. If, on the other hand, you bought an old, seasoned 8% coupon MBS with a short to intermediate final maturity, you simply extend the high coupon, increasing the yield of your portfolio. The 5% MBS can be defined as a 'convex' bond while the 8% MBS is known as 'negatively convex.'

The main point here is that there is more than one way to skin a cat in this business. In this case, you don't have to short housing stocks to make a bet on a slowdown in housing. This is a lower-risk (albeit less sexy) way to play the slowing in housing. One last point. If the bond market were to take a tumble, that would be the time to sell the 8's and buy the 5's, or 'adding convexity' to your portfolio. We have this trade on and expect to leave it on until both the level of rates and the shape of the curve changes. Not meant to be advice, but something worth considering if you thought housing were going to slow-like we do.

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Positions in various MBS

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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