ARM Update

March 30, 2020

Last week, the Fed announced plans to conduct open-ended quantitative easing and expanded its assets purchases to include corporate bonds.  Treasury market liquidity remains challenged, but there are tentative signs that the Fed’s easing measures are working their way into markets.  With a risk-on tone later in the week, yield spreads on 5/1, 7/1, and 10/1 ARM cohorts tightened 5, 2, and 5 basis points, respectively.  Last week, the Fed committed to purchase mortgage-backed securities “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.”  As a result, 15- and 30-year fixed-rate mortgages tightened 69 and 65 basis points, respectively, and outperformed their adjustable-rate counterparts.

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 140 bp spread, almost 120 bps wider than they were in early-December 2018.  Longer-reset 7/1s and 10/1s have a 150 and 155bp spread, respectively, approximately 117 and 108 bps wider than levels in early-December 2018.  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 just one month ago.

Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased their spread concessions to fixed rates.  Spreads are wider by approximately 78bps on 7/1s versus their 15-year fixed rate counterparts.  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.

With two business days remaining in the month, issuance levels continue to remain weak as new ARM issuance for March has totaled 536.9mm.  Supply has been split amongst Fannie Mae (373.9mm), Freddie Mac (154.8mm), and Ginnie Mae (8.2mm).  Supply continues to be focused in 7/1s (244.1mm) with 5/1s and 10/1s issued in amounts of 74.9mm and 217.9mm, respectively.  For the fourth straight month, it appears no 3/1s will be 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 will likely come under 1 billion for the eleventh consecutive month.  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 March, hybrid ARM issuance represented ~ 0.70% 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:

A recent Vining Sparks’s 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:

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

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.
Copyright © 2021
This is a publication of Vining-Sparks IBG, L.P.
775 Ridge Lake Blvd., Memphis, TN 38120