CMO Market Update
February 10, 2020
CMO spreads to Treasury yields tightened 2 basis points last week. For perspective, CMO yields are near lows since the beginning of 2019, and yet spreads are within 10-15 basis points of their highs over the same period. Depending on class type and WAL, investors can find 60-80 basis points worth of spread in this sector. Capturing that pick up in this environment comes with risk, of course. One must be comfortable with the price volatility and contraction/extension risk that accompanies these investments.
Many depositories still see falling rates as the biggest risk to their balance sheets. And with rates so low already, portfolio managers most likely have cash on hand due to elevated prepayments and called bonds. In considering how to deploy that reinvestment, we have a variety of tools to assist in decision making. Our Investment Alternatives Matrix, typically published the second business day of each week, compares projected performance of a wide range of products across both parallel and non-parallel rate shifts. The CMO section (begins bottom of page 2) lists a generic description of issuer/class type, accompanied by the bond’s WAL range for -200/0/+200 basis point scenarios. This will give investors a feel for contraction and extension risk. Price Volatility, along with other measures like Effective Duration and Convexity, can be found in columns to the right.
The January Trade Summary is below for those that missed it last week.
January Trade Summary
Customer preferences usually create some stability when it comes to analytics on CMO trades, and that was the case again in January. Typical metrics, such as yield, WAL, duration, and convexity, were right in line with previous months’ results. The low-rate environment has led to lower projected yields purchased since last year, but as discussed in recent CMO updates, nominal spreads are wide when looking back at 12- and 36-month history, making this space attractive for investors. Where we do see variability month-over-month is in class type. PAC-1s saw the majority of activity, accounting for 60% of fixed rate trades.
Below are some notable points from this month’s results:
- Effective Duration declined from 2.5 to 2.2
- Effective Convexity less negative, from -1.0 to -0.7
- WAL dips below 3.0 at 2.9
- As mentioned above, PAC-1s saw the most activity by class type
- Sequentials still prominent with 37% of fixed trades
- VADMs very quiet with only a couple trades
Travis Nauert, CFA
Analyst, Investment Strategies
Vining Sparks IBG, LP