July 20, 2020
Last week, we continued to see a flattening of the yield curve resulting from strong demand for long-end Treasurys and a strong 30-year U.S. Treasury auction. On the data front, core CPI rose 0.2% month over month, a greater increase than expected and its first increase since February. On the week, yield spreads on Ginnie and conventional ARMs were unchanged while fixed-rate mortgages widened 2 to 3 basis points. On the month, ARMs remained stable while agency MBS tightened 19 bps in 15-years and 22 bps in 30-years. Mortgages have struggled to keep up with other risk assets recently due to heavy TBA mortgage supply during the peak summer home buying season.
Since the market dislocation in mid-March, ARM pricing spreads have tightened, but remain at attractive levels. For example, 5/1 conventional ARMs have a 52 bp spread, almost 22 bps wider than they were in March 2019. Longer-reset 7/1 and 10/1 conventionals have a 65 and 80 bp spread, respectively, approximately 25 and 33 bps wider. Relative-value players may find Ginnie 5/1s to be attractive with their 130 bp spread, approximately 93 bps wider than early 2019 levels.
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 5 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.
The ARM origination cycle was light last week, with 121mm in new issue ARM selling split amongst Fannie Mae (70.9mm), Freddie Mac (37.8mm), and Ginnie Mae (12.3mm). Supply was focused in longer-reset 7/1s with Fannie Mae and Freddie Mac issuing 30.7mm and 16.9mm, 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, but recently broke the 1-year run of monthly issuance under $1 billion, and increased supply to levels not seen in over two and a half years. 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. The decline closely tracks 5/1 hybrid ARM rate spread to the 30-year fixed mortgage rate, which has dropped to approximately 10 basis points. As of July, hybrid ARM issuance represented ~ 0.43% of overall MBS issuance.
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 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 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
- 7/11/19 ARRC releases white paper on using an average of SOFR to build an adjustable-rate mortgage product for consumers
- 2/5/20 Fannie Mae announces SOFR ARM loans beginning Q4 2020; LIBOR ARM loans should cease by year end 2020
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP