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Agency CMO PO Bonds TradingBy Udo Onwuachi, BA, MBA
Question:
My traders continue to overpay for PO bonds. Could you please
let me know thevariables to use when pricing and trading a PO
bond?Answer:
There are different types of PO bonds, such as PAC, TAC, SC,
SEQ, PT, STP SUP, POor Remics, etc.You must take the following
factors into consideration before submitting a bid orasking for a
PO bond:
The uncertainty of loan payments due to poor documentation and
human error;
Proper hedging instrument;
The number of hedging contracts that you need;
Costs of hedging;
Option;
Past cash flow;
Scaling up prepayment models vectoring out the PSA/CPR with
emphasis on keyattributes, modified duration, effective duration,
average life and convexityusing YB, Bloomberg or INTEX;
Forecasting payments given inflation, mortgage services fees and
loan balances;
Is the collateral backed by GNMA, FNMA, FHLMC or a private label
(whole loanCMO)?
PO(A) PO(B) PO(C)
PSA: 90% Base 110%
CPN WAVG: 5.94 8.9 5.60
CPN SDEV: 0.12 0.10 0.11
MAT WAVG: 307 311 300Figure 1:PO (A) PO(B) PO(C)
Effective Duration: 11.4 20.0 10.50
The PO with 20.0 effective duration is the most volatile, so
when you bid/ask youneed to know the correct OAS and the forward
yields curve, as you can see fromFigure 1 above. The correct way to
look at Figure 1 is that as a prop trader thisPO asset class will
appreciate or lose 11 to 20% in the event of a 100bps in
yieldchange.As a prop trader you want to shock the cash flow and
duration; this gives you anidea of where to bid. The goal is to
avoid overpaying for a bond and to avoidlosing out on a bid.PO(A)
PO(B) PO(C)
Duration: 4.0 8.6 3.49
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A prop trader should quantify the exposure of the prepayment
models risk withemphasis on the PSA if the deal is new and CPR if
the deal is a seasoned one. Bearin mind that major broker dealers
have their own matrix; it is imperative that youuse public
information in analyzing the price that you want to pay for a
bond.After all, Long Term Capital Management had its own matrix and
the model failed.The transparency and flexibility of your
prepayment model should allow the traderto modify the parameters to
reflect your PSA/CPR expectations.In trading agency CMO PO you
should remember that the PO depreciates in a rising
rates environment and appreciates in a low rate environment. You
goal is to beable to tell when to bid either using OAS or forward
yield curve. When bidding fora new issue it is imperative to
remember that the value of your PO will depreciatedue to
amortization, and discount value factors because the original
principledecreases every month. I have priced over a thousand of PO
(SUP, TAC, PT, STP,PAC, SEQ and REMICS); these bonds are not all
equal. Remember that the OAS is notthe be all and end all variable;
other variables such as the effective duration,LTV, FICO scores and
geographic analysis are as vital.The best thing for a hedge fund
manager to do is to visit an underwriter withhis/her own coupon
formula. Place an order instead of waiting for the underwriterto
sell you some PO nobody wants to buy, and then get a promise that
the value ofyour PO will not go down. I know and have seen
structures that were extremelyprofitable and remained so! The game
of PO trading is like Las Vegas: the house
never loses. You just need a seasoned trader who can go toe to
toe with the houseand come out on top.Always remember there are
times to buy and sell PO. The question is, do you knowthe right
time? And can you value PO within minutes and place a bid/ask price
ifyou have to?In conclusion, an agency CMO prop trader needs to
have an assumption based on thehistorical volatility vis--vis
effective duration, modified duration, and howspeed (PSA/CPR), in
addition to knowing the VaR of each PO.
