ARM Update

February 16, 2021

Amid prospects for additional federal spending, the yield on the 10- and 30-year Treasurys were up 4 basis points on the week, while the short-end of the curve held steady at 11 basis points.  On the week, yield spreads on Ginnie and conventional ARMs were unchanged while 15- and 30-year fixed-rate products tightened 4 and 2 basis points, respectively.  Over the last month, conventional ARMs have tightened 2 to 4 basis points while MBS spreads have widened 1 to 3 basis points.

ARM pricing spreads have tightened and are at levels seen during the first quarter of 2019.  Shorter 5/1 conventional ARMs have a 36 bp spread, almost 27 bps wider than the fourth quarter of 2018 lows.  Longer-reset 7/1 and 10/1 conventionals have a 40 and 45 bp spread, respectively, approximately 10 – 17 bps wider.  Adjustable-rate mortgage products remain an attractive place to put excess cash and liquidity without extending duration, regardless of portfolio strategy.

Factors such as diminished liquidity, lack of index sponsorship, and the small market size have slightly increased ARM spread concessions to fixed rates.  Spreads are wider by approximately 2 bps on 7/1s versus their 15-year fixed rate counterparts.  7/1s may offer better value than 15-years, but they are less liquid.  Overall, we continue to see relative value in 7/1s due to appealing yields, shorter durations, and less negative convexity than comparable coupon 15-year fixed rate MBS.  Investors concerned about potentially faster prepayments could focus on lower WAC new issue pools or moderately seasoned paper.

Issuance levels continue to drop as new ARM issuance for January totaled 104.4mm, a multi-year low.  Supply was split amongst Fannie Mae (100.3mm), Freddie Mac (1.8mm), and Ginnie Mae (2.3mm).  Supply continues to be focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 45.5mm and 33.4mm, respectively.  Minimal 3/1s (0.6mm) were issued as this shorter product continues to be largely abandoned by lenders and the GSEs.  In recent years, the monthly net supply of ARMs has run at a negative pace, while fixed rate products have grown at a much faster pace.  The decline closely tracks 5/1 hybrid ARM rate spread to the 30-year fixed mortgage rate, which has dropped to approximately 26 basis points.  As of February, hybrid ARM issuance represented ~ 0.24% of overall MBS issuance.

ARM Prepay Commentary

The overall prepayment of conventional hybrid ARMs reversed course again and decreased in January.  February-released factors indicated the prepayments of FNMA and FHLMC ARMs fell by 11.05% and 11.06%, respectively.  The prepayment speeds of FNMA 3/1s, 5/1s, 7/1s, and 10/1s slowed down by 26.83%, 11.95%, 10.35%, and 7.37%, respectively.  Similarly, prepayment speeds for FHLMC 5/1s, 7/1s, and 10/1s slowed down by 18.72%, 8.95%, and 5.03%, respectively.  The overall prepayments of GN II hybrid ARMs also experienced a decrease of 10.62% in January.  For the Treasury indexed GN II hybrid ARMs, the prepayments for GN II 5/1 and 7/1 cohorts fell by 13.53% and 8.11%, respectively.  In aggregate, FNMA and FHLMC ARM speeds dropped to 33.8 and 35.4 CPR while GN II decreased to 34.5 CPR.

Shorter-reset LIBOR-based Fannie 3/1s decreased 5.5 CPR to 15 and 5/1s fell 4.1 CPR to 30.2.  Longer-reset 7/1s slowed down 4.4 CPR to 38.1 along with 10/1s, which decreased 3.2 CPR to 40.2.  In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 29.4 CPR, 38.5 CPR, and 10.8 CPR, respectively.

ARM LIBOR Transition Update

The LIBOR to SOFR transition has come to the agency ARM market with more specificity.  Directed by FHFA, Fannie Mae and Freddie Mac announced that they will start to wrap SOFR based ARMs later this year although no specific date has been set.  The following table from a Vining Sparks’s publication describes the key features of the new SOFR ARM product:

For SOFR ARMs, both agencies introduced a batch of four basic types with standard 3-year to 10-year fixed-rate terms.  Each will float off of 1-month SOFR averages with a 6-month reset frequency instead of the 1-year reset that most LIBOR hybrids currently have.  Moreover, 1-month SOFR is a backward-looking index rate versus the forward-looking 1-year LIBOR.

A typical 1-year LIBOR loan margin in 225bps.  The margin on these SOFR ARMs needs to be higher to compensate for the shorter tenure of the 1-month index.  However, a higher reset frequency should also help to offset the term difference.  ARRC published a white paper in July 2019 on this topic and recommended that SOFR ARM loan margins be between 2.75% and 3% so that their fully indexed rate may be comparable to the annual reset 1-year LIBOR ARM consumer rate.  The agencies did not dictate a margin in the announcement, but it did impose a maximum margin of 300 bps.

The GSEs have recently stated that LIBOR loan applications would not be accepted past September 30, 2020, and they won’t be securitized after December 1, 2020.  Fannie Mae will start accepting SOFR ARMs on August 3, 2020, while Freddie Mac will permit them from November 16, 2020 and onward.  In their LIBOR Transition Playbook, the GSE’s provided the following timeline, which identifies key transition milestones for SOFR-indexed ARMs:

The administrator of LIBOR has announced it will cease the publication of one week and two-month LIBOR after December 31, 2021, and the remaining tenors after June 30, 2023.  Extending the publication of certain LIBOR tenors until mid-2023 would allow most legacy LIBOR contracts to mature before LIBOR experiences disruptions.

The vast majority of ARM loans are retained by banks.  The issuance of agency ARMs has been falling since the 2008.  Thus, the impact of this transition timeline may be relatively minor.  Should the current timeline for agency ARM transition stand, investors might expect lower ARM issuance as we move closer to year-end.

Recent SOFR ARM Announcements

Ricky Brillard, CPA

Senior Vice President, Investment Strategies

Vining Sparks IBG, LP

The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the projections. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC.
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