July 22, 2019
Yield spreads between hybrid ARMs and Treasurys widened slightly last week, 1 bp or so on average. US Treasury yields oscillated around firm data releases but dovish US Federal Reserve commentary. The broader bond market moved up in price, sending yields lower across the curve. ARMs lagged their fixed-rate MBS counterparts, with yield spreads tightening 1 bps on the 30-year fixed. We continue to see relative value in ARMs as they remain 35 to 53 bps wider compared to levels in early December.
The following chart reflects the week over week change in Z-spreads for ARMs. Z-spreads were mixed for GNMA products while FNMA and FHLMC products experienced tightening.
The ARM origination cycle continued last week, with 451mm in new issue ARM selling split amongst Fannie Mae (149mm), Freddie Mac (214.6mm), and Ginnie Mae (87.4mm). Supply was focused in Freddie Mac 7/1s (96.1mm), and Ginnie Mae 5/1s (86.1mm), and Fannie Mae 7/1s (85.4mm). Freddie Mac also contributed to gross issuance with 72mm in longer-reset 10/1s. With 635.4mm originated month-to-date, July issuance matches or exceeds levels from the previous 2 months with 8 business days remaining in the month.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New issue Ginnie 5/1 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.
- New issue Freddie 10/1s with ~ 4% WACs traded near the 102 handle. With interest rates down, ARMs (especially 7/1s and 10/1s) offer attractive yields with minimal extension risk and stable cash flows.
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 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.
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP