CMO Market Update

November 18, 2019

From a nominal spread standpoint, it’s been a quiet couple of weeks for the sector. Spreads for 5- and 10-year CMOs widened 1 basis point last week. PAC and Sequential spreads have moved only a basis point or two month-over-month (see Spread Snapshot below). However, we still see improved relative value in this space compared to where we started 2019.

In last week’s commentary, it was noted that we’ve seen persistent activity in CMOs involving cut-down coupons. Previous updates have mentioned that in this elevated prepayment environment, CMO investors might want to consider cut-down coupons to lower the price and risk to underperforming yields.

Our November Prepay Commentary was earlier this month. The publication notes the broad-based increases in prepayments “save for a couple low-coupon (2.5 and 3.0) cohorts.”

Last call for the October Trade Summary:

October Trade Summary (published – 11/4/2019)

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

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