With extension risk now an issue in the MBS market, the hybrid ARM sector is once again in the spotlight. Not only are ARMs a defense against extension, the sector also provides shelter from increased market volatility. And although agency fixed-rate MBS spreads have been widening, hybrid spreads have remained firm, JPMorgan Securities analysts said.
Furthermore, Deutsche Bank Securities analysts said that ARMs currently look cheap to 15-year fixed-rate MBS as well as other duration products on an OAS basis. A decline in traditional hybrid ARM supply in favor of option ARMs and fixed-rate MBS should favor the sector too, Deutsche analysts added.
On the supply front, new ARM issuance has been rather light, as existing ARM borrowers have been refinancing into fixed-rate mortgages. Additionally, it is not really clear whether Fannie Mae and Freddie Mac are going to increase their issuance as has previously been expected. Sources from the lender side said that an interesting phenomenon is that agency hybrid ARM production is light compared to private label ARM issuance, in part due to the "cannibalization" of 7/1 and 10/1 ARM I/Os by the fixed-rate I/O market. Yield curve flattening has also reduced some of the rate advantage the longer-reset hybrid ARMs hold over fixed-rate products. Also, the secondary markets are becoming more familiar with fixed-rate IO products, and their better valuations are being passed through to borrowers.
Countrywide Securities Senior Strategist Bill Berliner said that hybrid ARM product has a lot less extension "due to both the nature of the cashflow and prepayment behavior in the sector, since hybrid prepayment speeds will not slow as much as those of fixed-rate products." Berliner explained that hybrid borrowers do not necessarily want to be in an adjustable-rate product per se, but are just looking to minimize their interest expense. Along with the payment shock that accompanies the reset, this would still cause "prepayment momentum independent of the level of rates," Berliner said.
"I think right now the sector has gone through some pretty interesting machinations," Berliner said. He noted that both 3/1s and 10/1 are not seeing much production. However, 3/1s look to be the cheapest sector presently, adding that this is partly because the shorter the reset, the greater the proportion of the product that is comprised of the adjustable-rate tail. Since both the market and models assign high valuations to the adjustable-rate tail, discount price short-reset paper looks especially attractive at current levels, Berliner said.
In a recent report, UBS analysts highlighted the value in seasoned 3/1s compared to new production paper with supply and demand pressure causing hybrid spreads to move around. In the last few weeks, analysts said there has been selling of seasoned lower coupon 3/1s - some of which has been by REITs raising cash to buy back stock - resulting in widening spreads. By contrast, 3/1 supply in the new-issue market is down and spreads in the sector have tightened. As a consequence, seasoned 3/1s are now trading at lower nominal spreads and yields compared to new 3/1s. However, UBS analysts said that when the expected faster prepayments of the seasoned paper are taken into consideration, these discount hybrids present a better value than their newly issued counterparts. "Moving from new to seasoned 3/1 non-agency hybrids looks fair-to-good on a yield an total return basis," analysts said, adding that the seasoned paper picks up significant option adjusted spread and the tail is worth more.
Similarly, in a recent MBS Perspectives publication, Morgan Stanley analysts said that they like the low duration exposure in ARMs compared to fixed-rate mortgages considering the current rate environment, explaining that ARMs have a fast ramp up period as well as higher baseline prepayment speeds. Thus, the ARM sector should offer protection against extension when rates sell-off, Morgan Stanley analysts said, adding that shorter resets like 3/1s and 5/1s will be a natural choice for this strategy as these have faster baseline prepayment speeds and a shorter fixed-rate period relative to the longer resets like 7/1s and 10/1s. Analysts also believe that the supply technicals favor 3/1s as issuance in this reset has been declining in recent months. The 3/1 and 5/1 resets also look attractive versus 4.50% and 5% 15-year TBAs, offering better carry given expectations of delivery on these TBAs (speeds below 6% CPR) while discount hybrids prepay anywhere between 20% to 30% CPR after the initial ramp-up period.
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