Prepayments have been declining for some time, but it took last week's rate hike by the Federal Reserve to trigger a wave of buying of mortgage- backed securities.
"With less interest rate uncertainty after the Fed move, there's been more investor interest in all spread products," said Dale Westhoff, senior managing director of mortgage research at Bear Stearns. "But liquidity is still an issue here."
Fixed-income investors had been wary of mortgage-backed securities and other fixed-income securities before the Federal Open Market Committee's decision Wednesday to raise the federal funds rate a quarter point, to 5%.
In the week ended June 18 the Mortgage Bankers Association refinancing index was at its lowest since September 1997. Normally, fixed-income investors would jump to buy mortgages. When loans prepay during heavy refinancing periods, investors' principal is returned prematurely.
But Rick F. Cipicchio, a portfolio manager for Banc One Investment Advisors in Columbus, Ohio, observed, "Prepayments are down, and it looks like they will go lower." This was a positive for premium securities but a slight negative for discount securities, he said.
It was only within the last two weeks that Mr. Cipicchio began buying mortgages again, focusing on 10-year collateralized mortgage obligations known as planned amortization class tranches.
But after the Fed's rate action, Mr. Cipicchio noticed an improvement in the market as Wall Street started to sell a lot of the most generic mortgage securities, known as pass-through securities, he said.
Mr. Cipicchio remains bullish on mortgages because they continue to provide "quite a bit of yield for the risk you're taking," he said.
Mr. Westhoff said that foremost on investor's minds will be extension risk-the risk that loans do not prepay-because more than 90% of the mortgage-backed securities in the market comprise loans with a lower coupon than on mortgages being originated now.
On Thursday, some traders were attributing investors' increased demand to changes that Lehman Brothers adopted in its U.S. Aggregate Index-a benchmark used by many fixed-income investors to gauge their investment strategies.
"There was very good buying for a lot of accounts that try and passively replicate the index," one trader said.
One change in the Lehman Brothers index was a liquidity constraint, which increased the minimum size of issues that can be bought to $150 million, from $100 million, said Steve Berkley, managing director at the Wall Street firm.
Lehman Brothers also added commercial mortgage-backed securities to the index, recognizing their growing role in the market, he said.
Lehman's changes caught the attention of investors such as William F. Quinn, a director at Smith Breeden Associates Inc. in Overland Park, Kan. Some of the portfolios Smith Breeden manages are expected to beat the index, he said.
The size change "increases the ... mortgage weight in the index," he observed.
But the addition of commercial mortgage-backed securities gained the most attention among investors, many of whom expected the change, he added.