July 15, 2019
Demand for new-issue hybrid ARMs slowed, which resulted in yield spreads to Treasurys widening 1 to 2 bps. Minutes of the June FOMC meeting and the Fed Chairman’s testimony before Congress reinforced expectations for a rate cut at this month’s meeting, with several policymakers considering near-term easing to be appropriate. The broader bond market was mixed with yields lower on the short-end, but higher across the rest of the yield curve. ARMs outperformed their fixed-rate MBS counterparts, with yield spreads widening 4 bps on both the 15- and 30-year fixed. We continue to see relative value in ARMs as they remain 34 to 52 bps wider compared to levels in early December.
The following chart reflects the week over week change in Z-spreads for ARMs. Z-spreads tightened for GNMA, FNMA, and FHLMC products.
The ARM origination cycle was light last week, with 58.4mm in new issue ARM selling split amongst Fannie Mae (36.5mm), Freddie Mac (1mm), and Ginnie Mae (20.9mm). Like last week, supply was concentrated in Ginnie Mae 5/1s (20.9mm). Fannie Mae also contributed to gross issuance with 16.3mm in 5/1s and 12mm in 10/1s. June’s ARM issuance at 642.8mm was slightly higher than May’s originations (631.4mm), but issuance remains at multi-year lows.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New issue Ginnie 5/1 3s and 3.5s with approximately 5 years to reset traded at a moderate premium (+ $102). With the bulk of the market still at a premium, prepayment risk is still a concern for many investors, and 5/1 borrower prepayment speeds tend to be more muted than 3/1s.
- Seasoned Fannie Mega 7/1s with coupons around 2.75% and ~ 2.5-year resets traded at a slight premium. This conventional ARM has a generous cap structures relative to GNMAs at 5/2/5. This lends to lower price impacts from rising rates.
Last week, 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 transactions. 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.
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP