February 24, 2020
Yield spreads for new-issue hybrid ARMs remained stable last week, as the overall bond market rallied with yields falling further on economic worries related to the coronavirus. The yield on the benchmark 10-year note was down 5 bps to 1.47% and as of this morning, it is less than 1 basis point away from the all time low of 1.35% hit on July 8, 2016. Z-spreads were mixed for GNMA, FNMA, and FHLMC products. ARMs outperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages widening 3 basis points on the week.
Since the rally at the end of 2018, ARM pricing spreads have widened significantly, reacting strongly to each move lower in rates. For example, 5/1 ARMs have a 50 bp spread, almost 22 bps wider than they were in mid-February 2019. Longer-reset 7/1s and 10/1s have a 61 and 65 bp spread, respectively, approximately 23 and 15 bps wider than levels in mid-February 2019. Certainly, the environment for ARMs has changed dramatically over the years with the flattening yield curve, but today’s spreads are well wider than those seen during 2017 at lower dollar prices.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased their spread concessions to fixed rates. 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.
Last week, the ARM origination cycle saw levels not seen in a month, with 319.6mm in new issue ARM selling split amongst Fannie Mae (198.2mm), Freddie Mac (118.4mm), and Ginnie Mae (3mm). Supply remains focused in 7/1s with Fannie Mae and Freddie Mac issuing 123.3mm and 50.1mm, respectively. Fannie Mae and Freddie Mac also contributed to longer-reset 10/1 issuance with 73.8mm and 39.8mm, respectively. No 3/1s were issued as this shorter product continues to be largely abandoned by lenders and the GSEs. ARM gross issuance remains at multi-year lows as it came under 1 billion for the ninth consecutive month in January. Last year, the monthly net supply of ARMs ran at a negative $2-3 billion pace, while fixed rates grew at $20-30 billion each month. As of February, hybrid ARM issuance represents ~ .90% of overall MBS issuance.
On November 15, 2019, the Alternative Reference Rates Committee (ARRC) released recommendations on contract fallback language to be used for new closed-end residential adjustable-rate mortgages (ARMs). The recommended fallback language for each of these products is based on the following framework:
- Defining trigger events – The fallback language for ARMs identifies clear and observable triggers for the transition to the replaced index.
- Selection of a replacement index – Upon the occurrence of a triggering event, the ARM fallback language provides that the note holder will select a replacement index pursuant to a defined “waterfall.”
- Defining the spread adjustment between LIBOR and the replacement index – When an ARM transitions to using SOFR as the benchmark, the borrower should continue to pay an interest rate comparable to the LIBOR-indexed rate.
A recent Vining Sparks’ publication provides the latest developments and planning steps for the transition from LIBOR.
On July 11, 2019, the Alternative Reference Rates Committee (ARRC) released a white paper detailing how an average of the Secured Overnight Financing Rate (SOFR) can be used in newly issued ARMs in a structure that is comparable to today’s existing ARM loans. The white paper shows how SOFR can be used to develop products that are built on a robust reference rate that is grounded in market transaction. Here’s an overview of the ARRC’s proposed models of SOFR ARMs:
- Most aspects of a SOFR-based ARM would use the same conventions that currently exist in US Dollar LIBOR-based ARMs, including the range of fixed-rate periods available, the timing of payment determinations, and the structure of caps on the amount that mortgage payments can rise at the end of the fixed-rate period and over the life of the mortgage.
- However, a few key components would differ:
- These ARMs would be based on a 30- or 90-day average of SOFR, rather than 1-year LIBOR. Because SOFR tends to be lower than 1-year LIBOR, the margin for newly originated SOFR-indexed ARMs would likely be adjusted upward so borrowers’ overall floating-rate payments are comparable to existing LIBOR-based ARMs.
- In order to ensure that these SOFR-indexed ARMs can be offered at rates consistent with other competitive rates in the market, under the proposed models SOFR-indexed ARM, the borrower’s monthly floating-rate payment would adjust following the fixed-rate period once every six months rather than once every year, as is currently the market standard for LIBOR-based ARMs in the United States.
- To safeguard against unexpected payment increases to the borrower, the proposed models would cut the periodic adjustment cap to 1%. As a result, the borrower’s payment, even in a period of rapidly rising interest rates, would not change by more than 2% over a 12-month period, in accord with the current market convention for LIBOR-based ARMs.
The desk continues to look to bid odd-lot positions for both conventionals and Ginnies for clean-up. The disposition of odd-lot positions can result in enhanced transactional liquidity and higher earnings. Also, this is an opportunistic time to consider eliminating smaller line items that are subject to standard safekeeping and accounting fees that are more palatable for larger block sizes.
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP