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Sell short Treasury debt, buy agency SOFR floaters

| July 10, 2020

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.

Agency SOFR floaters have quietly become an attractive buy for portfolios benchmarked against most short Treasury indices. Coupons on new issue 2-year and shorter agency SOFR debt lately range between 17 bp and 28 bp. With yields on similar Treasury debt under 15 bp and the curve flat, SOFR debt stands to outperform its Treasury counterparts.

Spreads have tightened but stand wide to pre-Covid levels

Agency SOFR coupons have dropped since March but still remain wide to late February levels (Exhibit 1). Actual and indicative coupons on 6-month FHLB SOFR floaters in the last week have hovered around 17 bp or overnight SOFR + 7 bp, 12-month floaters around coupons of 20 bp or SOFR + 10 bp, 18-month floaters with coupons around 26 bp or SOFR + 16 bp, and 24-month floaters with coupons around 28 bp or SOFR + 18 bp.

Exhibit 1: Agency SOFR coupons have dropped since March but stand wide to pre-Covid-19 levels

Note: Data reflect coupons through June 18. Source: Amherst Pierpont Securities

SOFR has converged toward 2-year Treasury yields

SOFR floaters also stand to gain from the converging 2-year Treasury and SOFR rates. As 2-year Treasury yields have dropped since the start of April, the SOFR rate has gone up (Exhibit 2). Elevated agency SOFR debt spreads and converging Treasury and SOFR yields have started to lift the debt yields well above the Treasury. Agency SOFR floaters reset daily off of overnight SOFR, so the coupon on SOFR floaters should rise as the instruments reset.

Exhibit 2: SOFR and Treasury rates have slowly converged

Source: Bloomberg, Amherst Pierpont Securities

Treasury roll, floater coupon and embedded 0% SOFR floor

With limited opportunity for Treasury debt to roll down the curve, a higher SOFR coupon gives the agency debt an important income advantage if rates remain unchanged. If rates rise, the lower duration of the uncapped floating-rate SOFR debt should help price performance relative to maturity-matched Treasuries. If rates fall and go negative, the 0% floor on the SOFR index built into the agency debt means the instrument should still pay its margin and will increasingly trade like a fixed-rate instrument, mitigating some the duration advantage of Treasury debt in a rally.

Heavy issuance lately

The agency SOFR market lately has seen heavy issuance led by Fannie Mae and Freddie Mac (Exhibit 3). Issuance in March approached $140 billion alone, with Fannie Mae and Freddie Mac issuing 61%.

Exhibit 3: Fannie Mae and Freddie Mac have led a new surge in SOFR debt

Source: Amherst Pierpont Securities

Issuance in 2-year and shorter maturities has also dominated recent issuance (Exhibit 4). These shorter maturities made up more than 90% of the March flow.

Exhibit 4: Most of the issuance has come in 2-year and shorter maturities

Source: Amherst Pierpont Securities

Caveats: liquidity, risk-weighting

Agency SOFR floaters do need to compensate investors for lower liquidity relative to Treasury debt, and, for banks, their 20% risk-weighting instead of the 0% weighting on Treasury debt. For total return investors benchmarked against short Treasury performance and with sufficient liquidity elsewhere in the portfolio, the agency SOFR market looks compelling.

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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