CMO Market Update
November 12, 2019
CMO spreads to Treasurys tightened 2 basis points week-over-week. Not too bad considering the movement we saw in Treasury yields. The 3-year rose 15 basis points, while the 5-year (21 bps) and 10-year (23 bps) each rose greater than 20 basis points. CMO yields are approaching, although still below, their midpoint of 2019. Despite that, spreads are not far off their highs for the year.
In terms of activity last week, we saw several trades involving stripped down coupons, primarily 2.5% and below. We have written previously that in this elevated prepayment environment, CMO investors might want to consider cut-down coupons to lower the price and risk to underperforming yields. If you missed it, our November Prepay Commentary was released last week. The publication notes the broad-based increases in prepayments “save for a couple low-coupon (2.5 and 3.0) cohorts.”
If you missed it last week, please see the October Trade Summary below.
October Trade Summary
Last week’s update was not intentional foreshadowing. We referenced the increased VADM activity observed in September and questioned if the product would sustain interest during October. It not only sustained but accelerated. At 32%, VADMs accounted for nearly one-third of Agency CMO trades last month, by far the best month of 2019 for the class type. PAC-1s narrowly outpaced VADMs, making up 39% of trades.
Given the precipitous drop in rates this year, some investors could be anticipating a shift in market sentiment. One application of VADMs is to manage extension risk in the portfolio. While rising rates is still an unlikely scenario given the current outlook, it is less expensive to prepare for risk in advance, and before it is realized.
Other than the breakdown by Class Type, not much changed in terms of trade analytics. The average Projected Yield, Effective Duration and Convexity, and WAL was consistent with what we’ve seen throughout the second half of 2019. Customers tend to favor bonds in the 3-year space, which project to earn around a 2.25 yield. Fixed rate bonds continue to dominate activity by coupon type.
Travis Nauert, CFA
Analyst, Investment Strategies
Vining Sparks IBG, LP