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Curve inversion stalls spread tightening in Fannie Mae CMBS

| March 22, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A deepening inversion between the front-end and belly of the Treasury and swap yield curves has stalled a spread tightening trend in Fannie Mae 7/6.5 DUS pools, and modestly reversed the tightening in 5/4.5 pools. Investors in 5-year Treasuries now own the lowest yield of the on-the-runs, and are subject to +20 basis points of rolling up the curve as the security matures. Despite a modest tightening in broad-based investment grade credit indices over the past few weeks, shorter duration Fannie Mae DUS investors appear to be in-line with AAA and AA credit investors in requiring a bit of extra yield to offset the roll-up penalty.

Tightening credit competes with yield curve inversion

The final quarter of 2018 experienced a sharp widening in credit spreads as the equity markets sold off, and the FOMC increased interest rates as promised for the fourth hike of 2018 in December. The first quarter of 2019 has so far staged a meaningful recovery, with spread product broadly retracing the move, but for the most part remaining moderately to well above the 2018 tights. A multi-year history of Fannie Mae DUS pool spreads to the swap curve across maturity buckets (Exhibit 1) illustrates the recent tights that were reached in early 2018, as well as the widening and subsequent recovery over the past two quarters.

Exhibit 1: Fannie Mae DUS pool spreads to swap curve

Source: Amherst Pierpont Securities

It’s also noticeable in Exhibit 1 that the longer-maturity DUS pools have been trending tighter steadily since the beginning of the year, while the 7/6.5 pool spread tightening has lost some momentum, and the 5/4.5 pool spread has actually reversed and widened by a couple of basis points over the last few sessions. The reason for the slow-down and reversal in the shorter maturity spreads might be due to the inversion in the front-end of the Treasury and swap yield curves (Exhibit 2).

Exhibit 2: Fannie Mae DUS and investment grade credit spreads vs curve inversion

Source: Bloomberg, Amherst Pierpont Securities. Note: reflects data through 3/18/2019.

Fannie Mae DUS spreads generally track changes in investment grade credit spreads, though they are more strongly correlated to the AAA and AA spreads, as Fannie Mae DUS pools are guaranteed for timely payment of principal and interest, like their residential mortgage loan cousins, and implicitly benefit from Fannie Mae’s corporate debt rating (Aaa/AA+). The broad investment grade index in Exhibit 2 is composed of about 50% of debt with BBB ratings. The spread has continued to tighten moderately over the past month from a spread of 125 bp to about 120 bp (though in the last several sessions it has widened back to 122 bp). It is evident from Exhibit 3 that most of the recent grind tighter has been due to the BBB sector outperforming, while the higher-rated AAA to A credits have moved mostly sideways.

Exhibit 3: Investment grade spreads to Treasury curve by ratings category

Note: Ratings category spreads represent a market value weighted average spread to Treasuries of bonds in the exchange traded bond fund LQD, which tracks the liquid investment grade index. Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities.

The deepening inversion of the front-end of the Treasury and swap curves is shown in Exhibit 2. The spread between the 2-year and 5-year points of the curves crossed into negative territory early in 2019, becoming more steeply inverted as the FOMC has turned more dovish and the global economy appears to have weakened.

An uphill climb for 5-year investors

Shorter duration investors in Fannie Mae 5/4.5 and 7/6.5 DUS pools are now facing less favorable roll-down prospects with their bonds priced off an inverted swaps curve. It’s reasonable for these investors to require an extra few basis points of yield to compensate for the diminished potential price appreciation of rolling up the inverted curve. Credit term structures in highly rated securities continue to benefit from being relatively steep (Exhibit 4), but should the Treasury and swaps curves continue to invert, there might be similar pressure from investors to increase spreads in the short-end to offset roll-up.

Exhibit 4: Credit spread term structures

Note: Fannie Mae DUS is the spread to swap curve; Apple and Microsoft curves are debt spreads to Treasury curve. Source: Bloomberg, Amherst Pierpont Securities.

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