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Negative carry and roll-up widens shorter maturity spreads

| June 20, 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.

The steep inversion in the front end of the yield curve has pressured spreads on short-maturity, highly rated debt a bit wider, including those of agency CMBS. The negative carry  is tough on levered investors and the optics of rolling up the yield curve is not appealing for total return accounts.  Luckily the curve is unlikely to stay this way for long, and how investors can position in agency CMBS depends on their Fed view and their use of financing.

Curve inversion pushes front-end spreads wider

Over the past few weeks spreads of shorter duration agency CMBS have widened more than spreads of comparable longer duration bonds. The term structure of Fannie Mae DUS spreads has flattened over the past year (Exhibit 1). Spreads for shorter-term 5/4.5 pools have risen 20 bp, from just over 20 bp in June 2018 to the mid 40s currently, while spreads for 15/14.5 pools have increased more modestly from 75 bp to the low 80s.

Exhibit 1: Fannie Mae DUS pool spreads to Treasuries

Source: Amherst Pierpont Securities

Over the last few weeks Fannie Mae DUS 5/4.5s have continued to cheapen on a relative basis compared to the longer duration pools. This is also apparent in Freddie Mac K-deal spreads (Exhibit 2), where 3-year spreads have risen by about 15 bp since mid-April, compared to a 1 to 3 bp rise in 10-year and 7-year spreads, respectively.

Exhibit 2: Freddie K-deal spreads to swaps

Source: Amherst Pierpont Securities

The relative spread widening in the short end of the credit term structure isn’t confined to agency CMBS – it’s also apparent in Aaa and Aa corporate credits (Exhibit 3). Comparing Microsoft (AAA/Aaa) and Apple (AA+/Aa1) debt securities, and Fannie Mae DUS pools (Aaa) indicate that over the past three months, spreads in the 3-year to 5-year sector widened more than those in the 10- to 15-year part of the curve.

Exhibit 3: Change in spreads to Treasuries – 3/17/2019 to 6/17/2019

Source: Bloomberg BMRK g-spreads, Amherst Pierpont Securities

The recent relative cheapening in the short end of agency CMBS and highly rated corporate debt has occurred as the front-end of the Treasury and swaps curves have become much more deeply inverted (Exhibit 4). The steep inversion in the front end has resulted in two wrinkles in the market that have contributed to the cheapening:

  1. A lot of high quality paper, shorter maturity securities have become negative carry, because the cost of financing is greater than the yield on the debt. That makes buying the debt less attractive to most levered investors, including bank and insurance portfolios, that typically earn additional spread by lending their securities in the repo market. Banks and insurance companies are heavy buyers of the Aaa-rated tranches of agency CMBS.
  2. The curve inversion means very high quality, and therefore lower yielding securities with three years or less to maturity are immediately rolling up the curve, making  their projected total returns flat to negative under a static yield curve scenario.

Exhibit 4: Steepening inversion of Treasury and swap yield curves

Source: Bloomberg, Amherst Pierpont Securities

Total return investors 

Two examples of Freddie K A2 securities illustrate the type of spread differentials between these short- and longer-duration agency CMBS (Exhibit 5). The N-spread on the FHMS K25 A2 is 35 bp, which at 0 CPR produces a 2.03% yield. The cost of financing the bond using overnight repo is currently 2.52%,  and with a weighted average life of 3.23 the bond would effectively roll up the yield curve by 5 bp over the next 12 months. The combination makes the shorter-duration bond negative on a projected carry and rolldown basis for levered investors assuming a static yield curve over the next year.

Exhibit 5: Comparison of Freddie K A2 pieces

Source: Bloomberg, Amherst Pierpont Securities

Luckily, no one expects the curve to be static and many investors don’t use financing. The curve and the fed funds futures market are pricing in 75 bp worth of rate cuts by year-end 2019.  That scenario would pull repo down towards 1.60% by January 2020, likely result in a 3-year bond rolling down the curve instead of up, and the steeper curve and lower financing cost would potentially re-tighten spreads of short-duration agency CMBS back the low 20s of early 2018. In a Fed easing scenario the shorter-duration bonds like the FHMS K025 A2 are an attractive investment for total return accounts.

Levered accounts – or any investors who do not think the FOMC will begin cutting rates this year – can benefit by extending in duration with the FHMS K093 A2. Although overnight repo would still make the bond slightly negative carry, term repo to 12/31 is lower at 2.32%, and would put investors back into a positive carry trade of about 20 bp. The nearly 10-year WAL security is also projected to benefit from 5 bp of rolldown in a static yield curve environment and potentially another 5 bp of spread compression.

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