CMO Market Update
July 13, 2020
Last Week’s Activity
Last week, we saw a continuation of recent trends in the CMO space. Investors are seeking lower cut-coupons, ranging from 1.50% – 2.50%, and collateral with slower prepayment projections, such as 100% New York and low max loan balances (150k-200k). While sub 2.0% coupons can be can be found at reasonable dollar prices, bonds with favorable collateral are almost certainly accompanied with a sizable premium. One can think of this as an insurance premium as prices, mainly due to lack of supply, and prepayments, due to the rate environment, are elevated in general. In other words, investors are willing to pay a little extra for prepayment protection with the hope of writing down premium more smoothly over the life of a bond.
Another point of interest is that some investors are showing a willingness to accept wider payment windows. While consistent, predictable cashflow is desirable for many, investors are having a difficult time finding a desirable yield without taking on some kind of risk with which they were previously uncomfortable. Realistically, this means taking on some extension risk in the event that rates pop up from current levels.
After holding steady through most of June, spreads to Treasurys for fixed-rate CMOs tightened 5bps last week. Spreads have been trending tighter since late March when they reached a high watermark in the midst of the coronavirus pandemic and subsquent Fed easing. With that said, CMO spreads are still relatively wide when looking back over a 1-3 year time period. Below is a graph of spread ranges in 2020.
For those that missed it last week, the June Trade Summary is included below.
Monthly Trade Summary
Customers were extremely active in the CMO space during the month of June. Activity was defined by primarily one-way flows, with investors buying bonds outright from cash on hand as called bonds and prepayments continue to provide a source of funds. For the third consecutive month, we saw a meaningful amount of floating-rate CMOs purchased, albeit a smaller percentage than in the first two months of the second quarter.
Projected yields on fixed-rate coupon purchases dropped, which isn’t surprising as many investors have expressed an aversion to high premiums and an expectation for elevated prepayments in the current rate environment, thus leading them to lower cut coupons. Another metric that stands out is effective convexity. Remember, this simply tells us about the price behavior of a bond and, in this case, some limited upside potential, which makes sense given how low rates are at this point. Prices will most likely decrease by a greater amount than they would increase for a given parallel movement in rates. There simply just isn’t much more room for rates to go on the downside. Another factor to consider, we are in an unprecendented environment, and models are surely being stressed. As things hopefully continue to normalize, we would expect for less extreme outputs, but time will tell.
In terms of Class Type, Sequentials accounted for about 2/3 of trades, far outweighing PACs and VADMs. Although Sequentials usually see the majority of activity, the breakdown had been more evenly split with PACs in recent months.
Travis Nauert, CFA
Analyst, Investment Strategies
Vining Sparks IBG, LP