April 2, 2018
Yield spreads between new-issue hybrid ARMs and Treasuries were 1 to 2 bps wider last week. The widening can be attributed to the recent rally in bond prices and a reflection of the increased prepayment risk on newly issued bonds with higher weighted-average coupons (WAC). For example, newly originated 7/1s for settlement in May have an average WAC of 4.24% compared to 3.54% in December.
The flatter curve (lowest 2s/10s spread of the cycle reached last week) also increases the potential for these higher WAC loans to refinance into a fixed rate mortgage as well as a new ARM. The spread between a 30-year fixed rate mortgage and a 7/1 currently stands at just 29 bps compared to 71 bps one year ago.
Last week, activity was primarily focused on the following:
- Short Resets – Lower premiums and the recent increase in LIBOR (see graph below) has contributed to higher yields on these pools. Investors are targeting conventional short resets (6- to 24-MTR with 5/2/5 cap structures) to potentially benefit from further increases in market interest rates. In many cases, current prepayment activity shows the temporarily elevated levels common to bonds nearing their initial reset dates. However, based on historical patterns, prepayment activity generally declines after the bonds reset. Using a vector to model this behavior shows that seasoned short resets can compare favorably to other adjustable rate alternatives.
- GN 3/1 2s – Demand has picked up for this product as buyers have resurfaced after spreads widened out 12 bps during March.
- GN 5/1 2.5s and 3.0s – 2.5s are trading just below par, while 3.0s are trading near $101 and offer more protection in rising rate environments.
Metrics for some commonly traded structures are below:
Michael S. Erhardt, CPA
Senior Vice President
Vining Sparks, IBG