October 28, 2019
Yield spreads on hybrid ARMs to Treasurys tightened 1 to 2 basis points last week, while most mortgage-related sectors experienced a mixture of spread tightening and widening. The 15-year fixed-rate mortgage saw spreads tighten 1 basis point and the 30-year fixed-rate mortgage experienced spread widening of 2 basis points. The broader bond market moved down in price, sending domestic yields higher across the curve. Political risks such as a no-deal Brexit and U.S./China trade tensions have recently lessened and in response, global sovereign bond yields have risen. We continue to see relative value in longer-reset 7/1s and 10/1s as they remain approximately 38 and 40 bps wider, respectively, compared to levels in early March.
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 continued last week, with 208.7mm in new issue ARM selling split amongst Fannie Mae (65.6mm), Freddie Mac (138.2mm), and Ginnie Mae (4.9mm). Supply was primarily focused in 7/1s with Freddie Mac issuing 75.1mm. Fannie Mae and Freddie Mac also contributed to longer-reset 10/1 issuance with 33.6mm and 37.6mm, respectively. With 760.2mm originated month-to-date, October’s ARM issuance levels have exceeded the previous five months levels with four business days remaining in the month. ARM gross issuance remains at multi-year lows as it came under 1 billion for the fifth consecutive month in September.
Hybrid ARM issuance remains quite low. The monthly net supply of ARMs continues to run at a negative $2-3 billion pace, while fixed rates are expected to grow at $20-30 billion each month for the rest of the year. As of October, hybrid ARM issuance represents ~ 0.87% of overall MBS issuance. Nevertheless, issuance volumes have been at their highest levels in Ginnie Maes, followed by Freddie Mac and despite the meager volumes, October hybrid ARM issuance as a percentage of overall MBS issuance has trended slightly higher versus August and September.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New issue Ginnie 5/1 3s with ~ 5 years to reset traded around the $102 handle. 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 in most rate environments.
- New issue Fannie 10/1s with ~3.8% WACs traded at a moderate premium (~$102). Compared to GNMA hybrids, agency hybrids have a more generous cap structure – typically 5/2/5 vs. 1/1/5 – which allows the coupon to move more if rates move up more dramatically.
On July 11th, 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.
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