CMO Market Update

June 29, 2020

With month and quarter-end tomorrow, I’d like to provide some context for recent spread movements in the CMO space. Week-over-week spreads were unchanged and month-over-month they tightened slightly, around 6 to 8 basis points. For the quarter, spreads receded from their high watermarks found in the height of the coronavirus pandemic. They reached those levels as investors sought alternatives to traditional agency MBS while the Fed expanded its balance sheet to heal dislocations in that market. But, when looking at a year-to-date timeframe, CMO spreads are still wider for the year, anywhere from 10 to 20 basis points depending on maturity and structure. Below is a condensed version of the Treasury Yield and Spread Snapshot from the overall commentary.

A longer time period paints a more compelling picture. Using 3 years of history, spreads for 3-year Sequentials, which is a typical investment for our customers active in the space, remain above +1 standard deviation.

With this data in mind, one could argue that the Agency CMO space is attractive on both a recent and historical basis. So, why aren’t all investors flocking to this sector? Two common hurdles are prepayment risk and premium risk. With interest rates at such low levels, and recent Fed guidance suggesting they are here to stay, many fear cashflow returning sooner than expected. Couple that with high dollar prices and suddenly your yield might not be what you expected at purchase. To combat these challenges, investors are seeking collateral types such as 100% New York or low-max-loan balances that traditionally are less exposed to prepayments. Alternatively, others are seeking low cut-coupons to find lower dollar prices and shield themselves from premium risk. Recently, these cuts have come as low as 1.25%-1.50% with some bonds offered near par or at discount.

Looking ahead, in the coming weeks we will review trade activity for June with the Monthly Trade Summary. It will be interesting to see the percentage of trades in fixed versus floating rate bonds as the latter increased in the previous two months.

Travis Nauert, CFA

Analyst, Investment Strategies

Vining Sparks IBG, LP

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