Inverted Curve Throws Kink Into MBS Values

One thing about the mortgage-backed securities market that an investor can always count on is that valuing an instrument with so many moving parts isn't easy. But generally most techniques to value MBS point in the same direction, even if their absolute levels may be very different. Not so today, and that is creating a conundrum for some MBS investors. Analysts at Bear Stearns recently offered guidance on how to evaluate the conflicting signals from two longtime measures of MBS value - nominal spreads and OAS.

In recent weeks when an investor tried to value a par MBS by looking at its nominal spread against the 10-year swap rate and also looked at that same security's value using OAS methodology, the results were divergent, according to Bear Stearns. Nominal spreads were recently near the high point of the last couple of years telling investors that the bonds were cheap, while OAS valuations were tight, or that the bonds were expensive.

"The signals may seem confusing, but OAS is pointing in the right direction," said the Bear Stearns report, authored by managing director Steven Abrahams and analyst Victor Gao.

The reason for the divergent signals? The inverted yield curve. The spread between the two- and 10-year Treasury notes has been negative for some time now, and late last week it was about 15 basis points negative. That signals lower long-term rates in the future if the Federal Reserve inflation fighting posture is successful.

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