May 7, 2018
Yield spreads between hybrid ARMs and Treasuries were unchanged last week, as the overall bond market traded in a relatively narrow range. Seasoned bond selling in the secondary market continued last week, with most of this activity consisting of post-reset 5/1s. Yields on post-resets have increased sharply this year as a result of 12-month LIBOR increasing from just 1.69% in early September 2017 to 2.77%. Flows generally reflect the anticipation of faster prepayment speeds as borrowers’ interest rates adjust higher.
Issuance for April rebounded as expected and totaled $1.5bn, a 54.1% increase over the previous month. The largest increase could be found in 7/1s, with volumes totaling $601.6mm, an increase of $200.4mm from the prior month. 7/1s continued to make up the largest reset type, accounting for nearly 40.0% of total originations. 3/1s declined $9.0mm to $151.2mm, accounting for a relatively small 10.0% of total production. The flatter yield curve and narrowing spreads between longer-term fixed rate options and the shorter resets has diminished consumer demand for the shorter reset types.
Hybrid ARM prepayments rose approximately 5% in April, roughly meeting expectations given the impacts from seasonality and higher sensitivity to turnover. In aggregate, Fannie ARM speeds advanced 1.1CPR to 22.4CPR. Fannie 5/1s sped up 1.5CPR to 27.4CPR, 7/1s accelerated 1.2CPR to 19.4CPR, and 10/1s increased 0.5CPR to 14.0CPR. There was a spike in prepayments in post-resets (5/1s at first reset date), as speeds hit 90CPR this month, up another 5CPR from last month.
Last week, activity was primarily focused on the following:
- GN 3/1 2.5s – Recently trading modestly under par with spreads widening due to the cap risk.
- GN 5/1 3.0s – Trading slightly above par.
- Short Resets –Investors continue to target conventional short resets (6- to 18-MTR with 5/2/5 cap structures) to potentially benefit from further increases in market interest rates. In many cases, current prepayment activity shows the temporarily elevated levels common to bonds nearing their initial reset dates. However, based on historical patterns, prepayment activity generally declines after the bonds reset. Using a vector to model this behavior shows that seasoned short resets can compare favorably to other adjustable rate alternatives.
Michael S. Erhardt, CPA
Senior Vice President
Vining Sparks, IBG