CMO Market Update

July 19, 2021

Readers will find below the Treasury and CMO sections from last week’s Investment Alternatives Matrix. What a difference a week makes. Earlier this morning, the 10-year Treasury yield dipped below 1.20% and the 2s-10s spread tightened to less than 100bps.

Nominal CMO spreads have been resilient all year, refusing to tighten or widen significantly on a year to date basis. If this most recent trend holds, we might see projected yields for 3- to 5-year bonds, the area of the curve in which our customers typically traffic in this sector, grind closer to 1.00%. As shown in the monthly trade summary at the bottom of this update, investors have been able to purchase a 1.00% yield or greater on average this year. While these levels may not be exciting in absolute terms, it still beats what investors saw for the majority of 2020.

Most depository institutions we speak with see current rate levels or further declines as the greatest risk to their portfolio and balance sheet. With this and the recent rally in mind, the appetite for cut-coupon CMOs may only intensify as portfolio managers aim to mitigate prepayment risk. Our trade desk continues to field a healthy amount of inquiries for 1.00% – 1.50% coupon cuts off both traditional and jumbo collateral and across issuers. In order to reflect what customers find to be most relevant in this sector, readers will see that most of the selected examples for our weekly Matrix fall within the parameters discussed.

Monthly Trade Summary

While yields for longer maturity Treasurys declined during the quarter, yields for short- to intermediate-term government bonds were more resilient. Yields for 2- and 3-year Treasurys increased 9 and 11 basis points, respectively, while the yield for the 5-year Treasury declined 5 basis points. So, a bit of a mixed bag, but less drastic moves than were seen on the long end of the curve, where the 10- and 30-year yields decreased 27 and 32 basis points. Given the latter, one might have expected yields on new CMO purchases to decline month over month. But, as a reminder, our customers typically traffic in the 3 – 5 year portion of the curve when it comes to CMOs. So, as it turns out, projected yields on new investments were right in line with recent months at 1.17%.

While not a significant change month over month, customers did extend out on the curve with June purchases. This is evidenced by the increase in WAL from 3.9 in May to 4.2 in June. The last time we saw customers purchase bonds with a 4-year WAL or greater on average was in March of this year.

In terms of coupon types, fixed-rate bonds continue to make up the majority of purchases. However, floating-rate bonds accounted for just over 15% of trades in this sector for the second consecutive month. This is notable given the dropoff seen in March and April.

Lastly, customers were honed in on Sequential structures last month. As shown in the table below, PACs accounted for more than 50% of CMO trades in the prior 4 months, while activity in VADMs continues to be virtually non-existent.

Travis Nauert, CFA

Analyst, Investment Strategies

Vining Sparks IBG, LP