CMO Market Update
July 6, 2020
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