Take advantage of steep spread curve in agency CMBS
admin | August 13, 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 CMBS spreads for maturities out to 10-years have tightened to historic lows over the past few weeks and continue to hold near that range. Fed buying operations in Fannie Mae DUS and Freddie K-series have primarily focused on the most liquid bonds in the 10-year part of the curve, leaving spreads in longer-term agency CMBS a bit wide. Although the longer-term spreads have been gradually tightening, investors can still take advantage of the steeper spread curve by extending in duration and picking up 20 bp to 30 bp of additional yield compared to 10-year paper.
The Fed’s agency CMBS buying operations were announced on March 23 and began on March 27. Spreads peaked on March 24 (Exhibit 1) but recovered fairly quickly as markets responded to both monetary and fiscal policy measures announced and implemented over the following weeks.
Exhibit 1: Fannie Mae DUS spreads (longer maturities, at issuance)
Source: Amherst Pierpont Securities
The Fed’s buying of agency CMBS has been concentrated in the 10-year sector in Fannie Mae DUS and Freddie Mac K-series, helping spreads in 10- to 12-year maturities return to pre-COVID levels by mid-May. Spreads in longer maturity agency CMBS have been trending down more slowly, and continue to linger wide of pre-COVID levels, with the result that the spread curve has steepened (Exhibit 2).
Exhibit 2: The spread curve has steepened in the long end
Source: Amherst Pierpont Securities
Investors can extend duration from Fannie Mae 10/9.5 into Fannie Mae 15/14.5 or 20/19.5 and pick up 20 bp to 30 bp of additional yield. As longer-maturity agency CMBS spreads continue to normalize, these bonds should outperform by 8 bp to 9 bp. The market isn’t quite as deep in longer-maturity DUS: 10/9.5 issuance has averaged $1.5 billion per month for the last few years, compared to 12/11.5 and 15/14.5 DUS pools, which have both averaged about $500 million of issuance per month so far in 2020. Longer-term 20- and 30-year DUS pools do come to market but issuance is typically small and erratic – varying from zero to $20 million per month – with an occasional large pool such as a $198 million 20/19.5 that settled in February 2020.
Banks or other portfolios with duration targets can extend into the longer-maturity DUS and mitigate the additional duration by entering into pay-fixed swaps. This allows investors to pick-up the additional spread available out the curve and potential outperformance as spreads tighten while maintaining their duration bogeys.
Ongoing support from the Fed
The Fed’s agency CMBS buying operations have focused on the 10-year and in sector. The current weighted average life (WAL) of their holdings is 9.1 years (Exhibit 3). There has been some modest maturity extension to 10.4 WAL in Fannie Mae DUS pools, but the WAL of their Freddie holdings is quite a bit shorter at 7.74.
Exhibit 3: Fed agency CMBS holdings
Note: Data as of 8/5/2020. Source: Federal Reserve Bank of New York, Amherst Pierpont Securities
The Fed’s guidelines and results for each buying operation are shown in Exhibit 4. The operations have started to taper down, with the Fed outright passing on buying any bonds in four recent operations, and buying only $6 billion of a maximum $500 billion in the most recent DUS operation on 8/11/2020. By not formally halting the operations but minimizing purchases, the Fed can easily ramp back up should the market or economy deteriorate, and spreads widen precipitously. This implicit forward guidance should keep longer term agency CMBS spreads on a path towards normalization.
Exhibit 4: Fed agency CMBS buying operations
Note: Data as of 8/13/2020. Source: Federal Reserve Bank of New York, Amherst Pierpont Securities
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