September 16, 2019
Yield spreads on hybrid ARMs to Treasurys tightened up to 10 basis points last week, despite most mortgage-related sectors experiencing some degree of spread widening. The broader bond market moved down in price, sending yields substantially higher across the curve. We continue to see relative value in longer-reset 7/1s and 10/1s as they remain approximately 32 and 37 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 was light again last week, with 55mm in new issue ARM selling split amongst Fannie Mae (50.9mm) and Ginnie Mae (4.1mm). Supply was primarily focused in 7/1s with Fannie Mae issuing 35.1mm. Fannie Mae and Ginnie Mae also contributed to 5/1 issuance with 12.2mm and 4.1mm, respectively. ARM gross issuance remains at multi-year lows as it came under 1 billion for the fourth consecutive month in August.
Hybrid ARM issuance remains quite low. As of September, hybrid ARM issuance represented ~ 0.50% of overall MBS issuance. The ARM sector continues to be plagued with low supply and minimal new issuance.
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 $103 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 Mega 7/1s with coupons around 2.9% and ~ 5-year resets traded near the 102 handle. This conventional ARM has a generous cap structures relative to GNMAs at 5/2/5. This lends to lower price impacts from rising rates.
- New issue Fannie 10/1s with ~3.8% WACs traded at a moderate premium ($102.5+). 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