Pick up projected return in short Freddie Mac Ks
admin | June 28, 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 widened spreads of highly rated, shorter-duration securities, including agency CMBS. Freddie Mac K 3- to 4-year classes are now trading +35 bp wide to Treasuries, compared to +21 bp through most of the spring. This presents an attractive opportunity for total return investors to pick up additional return against Treasury or agency debt. The Freddie K bonds have potential to outperform by up to 33 bp over the next year if spreads remain static, with potential to add another 10 bp to 15 bp if spreads normalize.
Curve inversion and negative carry widen spreads
The market’s burgeoning conviction that the Fed will cut rates by up to 75 bp by year-end has steeply inverted the front-end of the yield curve compared to where it was just three months ago (Exhibit 1). Overnight financing rates, which stay closely tied to fed effective, remain in the area of 2.40% to 2.50% for general Treasury and agency collateral. This has created a “double whammy” for shorter duration Treasury and agency securities:
- The bonds are deeply negative carry as their yields are well below the financing cost; and
- Bonds with maturities under three years roll up the yield curve as long as rates remain unchanged – making their projected total returns relatively worse than bonds rolling down a steep curve.
Exhibit 1: Yield curve inverts as rate cut conviction increases dramatically
Source: Bloomberg, Amherst Pierpont Securities
These two factors have contributed to spreads on short-duration agency CMBS widening by 14 bp over the last few weeks, compare to 2 bp to 3 bp of widening in the longer-duration bonds (Exhibit 2).
Exhibit 2: Freddie K deal spreads, AAA-rated tranches
Source: Amherst Pierpont Securities
Capturing the additional spread
Total return investors can buy short-duration Freddie K securities outright as an alternative to agency debt or Treasuries, or on spread using a short Treasury or agency position as a hedge (Exhibit 3). The FREMF 2013-K34 A2 has a current yield of 2.03% using an N-spread of +35, an average life of 3.98 years and a modified duration of 3.69. A similar maturity and duration Treasury is the T 1.625 4/30/23, with a yield of 1.71%, a remaining maturity of 3.84 years, and modified duration of 3.70. The yield spread is 32 bp. Investors who want to hedge the interest rate risk can do so by weighting the face amounts so that the dollar value of a 1 bp parallel shift of the yield curve (DV01) is the same for both securities.
Exhibit 3: Similar duration agency CMBS vs Treasury security
Note: Pricing as of 6/25/2019. The agency CMBS is analyzed at 0 CPY. Source: Bloomberg, Amherst Pierpont Securities
Recall that the DV01s need to be calculated using the full price, that is the clean price + accrued interest.
The projected total return for both bonds is calculated across a variety of interest rate scenarios (Exhibit 4). As expected the FREMF 2013-K34 A2 is projected to outperform the Treasury by 0.32% to 0.34% over the 12-month horizon in all cases. The projected dollar return is about $3,600 per $1 million face of the Freddie K. The scenario analysis assumes that the spread between the securities is fixed across the horizon. The dollar returns in each case are worth about 9.2 bp, so if an investor hedges the interest rate risk using the Treasury, the yield spread could widen from 32.2 bp to about 41.3 bp before breaking even.
Exhibit 4: Projected total return agency CMBS vs Treasury security
Note: All scenarios assume the spread between the bonds is unchanged over the 12 month horizon.The base case assumes the yield curve remains static across the time period. The agency CMBS is analyzed at 0 CPY. Source: Yield Book, Amherst Pierpont Securities
An investor concerned about potential spread widening in agencies could choose an equivalent maturity agency debenture and hedge the agency CMBS using it. It reduces the yield spread by about 6 bp and lowers the projected total return difference between the two by a similar amount.
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