A legacy MBS IO that may get a lift from lower rates
admin | September 6, 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.
MBS that end up getting more coupon as interest rates fall often have to bear the impact of rising prepayments. But one levered play on lower levels of LIBOR is Option ARM basis IO. That niche would likely get a lift from further Fed easing, a potential slowdown in prepayments and possibly even the aftermath of LIBOR being replaced by SOFR in 2021.
The engineering behind an MTA basis IO
MTA basis IOs are bonds structured off of Option ARM deals issued before the 2008 financial crisis. The interest rate on loans behind these deals floats with 12-month MTA, or monthly Treasury average, while the interest rate on the MBS issued float with 1-month LIBOR, hence the basis IO. MTA is calculated as the 12-month moving average of 1-year constant maturity Treasury rates, so MTA and LIBOR can differ substantially. While structures will vary deal to deal, these bonds usually benefit from an increase in the spread between a high value of 12-month MTA and a lower value of 1-month LIBOR.
To be concrete, one example of an MTA basis IO is CWALT 2006-OA21 X. The X class is stripped off of the entire collateral balance. The bond’s coupon is derived from the difference between the collateral net WAC and the senior and subordinate bonds. The IO gets paid at the top of the interest payment waterfall, where absent the need to repay interest shortfalls, its coupon will be paid pro-rata with the senior certificates. The senior and subordinate bonds in the deal are structured as 1-month LIBOR floaters. Therefore, as LIBOR decreases and MTA lags, the basis IO coupon will increase. For example, if we run the bond at its trailing 6-month CPR, CDR and severities and assume implied forward MTA and LIBOR, then at a $7-24 dollar price the bond is a 9.17% yield. However if LIBOR follows the forward curve and then fixes at the value in December 2021, when LIBOR could sunset but when MTA forwards continue to rise, the bond’s yield increases by roughly 125 bp.
The IO is susceptible to the same type of prepayment risk as conventional IO. Faster prepayments will shorten the cash flow and reduce the yield, absent a material increase in the coupon. Holding all else constant and increasing the 6-month speed by 50% takes the bond’s yield from 9.17% to just over 50 bp. The IO is also sensitive to notional balance reductions associated with loans defaulting and generating losses. Profiles vary across Option ARM IO as there can be deals where the assets and liabilities are pegged to the same index. Additionally, the IOs may not in fact be pure IOs at all. As is the case with the CWALT bond, there are often PO components to the cash flow. Additionally, IOs may not always sit atop the interest payment waterfall. All these variables will factor into an individual bond’s performance in different rate and prepayment scenarios.
Emerging relative value
These bonds have become increasingly attractive given the recent decline in 1-month LIBOR. For the past five years, 1-month LIBOR has generally has run flat or above 12-month MTA. As of the end of July, LIBOR was 22 bp below MTA and currently sits 30 bp below the lagging MTA index. Given the shape of the forward curve, this basis appears poised to continue to widen, potentially increasing the coupon on these IOs, increasing their yield even if prepayment speeds were to remain elevated on the collateral (Exhibit 1).
Exhibit 1: MTA LIBOR basis appears poised to widen
Re-performing Option ARM collateral, or RPLs, prepay significantly slower than always performing loans, or APLs. Given this, IOs with large populations of RPLs should outperform those with large populations of APLs. Re-performing Option ARM loans have prepaid slower than 5 VPR on average compared to APLs, which are currently prepaying at roughly 20 VPR. Admittedly, a high concentration of RPLs may mean the coupons on modified loans may be fixed for some period and capped at a certain rate, potentially mitigating the effect of the MTA-LIBOR basis. (Exhibit 2)
Exhibit 2: Re-performing option ARM loans prepay much slower than APLs
Application for MBS portfolios
MTA basis IO, unlike traditional IO, trade with positive duration and can be used as a way to add duration and carry and reduce portfolios exposure to LIBOR. The bonds exhibit positive duration largely as a result of the fact that while the cash flow is getting shorter due to rising prepayments, the bond’s coupon is increasing. Given the fact that the loans backing these bonds are burnt out and often credit impaired, the prepayment risk and subsequent cash flow contraction is mitigated to some extent, increasing the benefit of the larger coupon. While prepayment risk in these bonds may be mitigated by the underlying collateral, call risk may not be and one of the biggest risks associated with seasoned non-agency IO. There is call risk associated with the holder of the clean-up call. Given this, look for MTA IO where the deal collateral factors are remote from the deals’ 10% clean-up call. These profiles should offer a reasonable yield even to a call scenario. One example of this type of profile is CWALT 2006-OA21 X. Running this bond to the ALIAS Pay Model Fair Value scenario at a dollar price of $7-24 produces a base case yield of roughly 11% with a yield-to-call that is still north of 5.5%. (Exhibit 3)
Exhibit 3: MTA IO; CWALK 2006-OA21 X – performance across scenarios
Potential policy upside
While challenging given the incongruity of index replacement language across the legacy market, MTA IO may have significant potential upside to LIBOR going away at the end of 2021. Language in certain trusts would effectively fix coupons on liabilities pegged to LIBOR at its last observed value. If MTA rose appreciably over a fixed LIBOR setting, basis IO would be the beneficiary of the widening between rising MTA and fixed LIBOR.