CMO Market Update

March 16, 2020

With constant updates flooding your news feed and inbox, I thought it would be helpful to recap a couple ideas and themes.

First, as has been the case since rates began their descent last year, the CMO space offers good relative value in the form of wide nominal spreads. For context, we previously estimated that spreads on 3 year PACs and Sequentials were well above their 1- and 3-year averages, by as much as one standard deviation. It was true last week. And now, after the Fed cut rates Sunday afternoon, it is still true today.

Second, and speaking of the Fed’s actions, holding cash is now even more punitive than it was before. To the extent that investors have cash on hand from called bonds and prepayments, one stands to earn even more income pick up investing in bonds than prior to yesterday’s news.

Let’s reconcile these two points. In general, investors stand to gain from investing in bonds and cash is punitive from an earnings perspective. Additionally, CMOs were already offering attractive relative value, both by today’s standards and recent history (1-3 years). All told, current events have made the case for this sector even more compelling.

Finally, I’ll leave you with the February Trade Summary one last time for reference. Month after month, we have seen projected yields decline. As 2019 progressed, it became clear that 3% yields were tough to find. Now, as we have moved into 2020, 2% has faded and then some. While the market is all over the place and levels highly subject to change, it is still useful to consider our Investment Alternatives Matrix to weigh tradeoffs and get a general sense of of where the market is. Emphasis on general.

February Trade Summary

Customers stuck to their game plan investing in CMOs with a WAL of around 3 years and an Effective Duration of 2. There was a slight shift towards bonds with less negative convexity, which makes sense in this environment. All else equal, more negative convexity translates to a less favorable price/yield relationship, i.e. less upside in terms of price appreciation when rates fall.

The biggest change month-over-month is the average projected yield that investors purchased. On average, customers purchased yields below 2.0%. And yet, spreads are wider than they have been in recent years. So, while absolute yield numbers may not seem attractive, the relative pickup still grabs the attention of investors.

Lastly, moving on to bond characteristics, investors focused solely on fixed rate bonds. And in terms of class type, Sequentials saw the most activity, accounting for 67% of trades.

Travis Nauert, CFA

Analyst, Investment Strategies

Vining Sparks IBG, LP

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