October 9, 2018
ARM prepayments were released last week, and the sector’s spreads dropped by 19%, in line with the move in fixed rates as day count and seasonal effects moved lower in September. 5/1 hybrid ARMs with 120+ WALA paid ~ 24 CPR, down 5 from last month and only 2 CPR slower than last September, when weighted-average coupons (WACs) were ~70bps lower. An even more pronounced slowdown occurred in 5/1 hybrid ARMs at their first reset, which have paid faster recently. 5/1 hybrid ARMs with 60+ WALA peaked just below 70 CPR this month, over a 20% slowdown versus last month’s 89 CPR peak. Last week’s prepayment report should be viewed as a positive for the ARM sector. While seasonal factors and reduced day count helped to slow post reset speeds, WACs continue to increase as more borrowers reset to higher rates, so the substantial slowdown should serve to calm anxieties over post reset prepayments. The technicals look favorable for ARMs in the fourth quarter with spreads lagging 15-year fixed rates, dollar prices are at year-to-date lows with the recent selloff, and seasonal ARMs are showing signs of taming to Fall 2017 prepayment levels.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- 5/2/5 cap structure Fannie Mega 5/1s with reset dates of ~ 6 months and gross WACs near 3.3% traded at a moderate premium
- Seasoned Freddie Mac 7/1s with short reset dates (inside 3 months) and coupons near 2.9% traded at a moderate premium
Fannie Mega 7/1s and Fannie Mae 10/1s at a moderate discount met decent demand last week. Dollar prices for conventional hybrid ARMs have been low for an extended period and generally, they have a higher minimum speed threshold, which translates into solid cashflows for the investor. In some cases, hybrid ARMs have higher option-adjusted spread (OAS) versus their fixed-rate counterparts and an appealing yield given their lower price volatility. Because hybrid ARMs reset off LIBOR plus a margin during the floating rate period, the investor is compensated with a higher coupon, which serves to mitigate extension risk. Since the bonds will reset higher, the price of the bond at reset is historically in excess of par (~ $101 – $103.5).
The following chart reflects the week over week change in LIBOR option-adjusted spreads for ARMs. GNMA tightened reflecting higher prices and outperformance. FNMA and FHLMC widened reflecting lower prices and underperformance.
Issuance increased very slightly for Freddie Mac, up $0.06B to $0.31B, decreased a slight $0.07B to $0.63B for Fannie Mae, and decreased markedly by $0.24B to $0.11B for Ginnie Mae.
September fixed-rate and ARM prepayments decreased significantly for all 3 agencies. Fannie and Freddie 30-year prepayments matched at an aggregate level just as they did last month.
Ricky Brillard, CPA
Vining Sparks, IBG