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Framing relative value in agency CMBS SOFR floaters
admin | April 9, 2021
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. This material does not constitute research.
Issuance in Freddie Mac K-Series CMBS this year has swung heavily toward floating-rate debt as the yield curve has steepened, adding to the menu of possibilities especially for banks looking for assets with low duration. But the agency’s embrace of SOFR adds a few wrinkles to marking relative value. At current spreads, the SOFR floaters look at least like fair value relative to fixed-rate K-Series if not marginally inexpensive, and the floaters operationally look like an easier way to get floating-rate exposure.
A growing series of Freddie Mac K deals have included an AS class varying in weighted average life from six years to 10 years and indexed to the trailing 30-day average SOFR rate. That class lately has priced around S + 25 bp (Exhibit 1). Since the beginning of 2021, floating-rate loans have accounted for more 50% of Freddie K-deal production; with two more floating-rate deals expected to price in the coming weeks it will raise the proportion of floating-rate deals to over 60% of production. Comparatively, floating rate loans comprised 30% of standard K-deal production during the first three quarters of 2020 and about 25% in 2019.
Exhibit 1: Margins at pricing and underlying rates of floating-rate K-deals
Note: Floating-rate classes range from 6- to 9.5-year terms.
Source: Bloomberg, Amherst Pierpont Securities
Investors can compare the recent AS classes to Freddie Mac K-Series A2 classes with roughly a 10-year weighted average life and a fixed coupon priced at swaps + 18 bp (Exhibit 2). Banks could use a last-of-layer swap hedge to convert the A2 class to a 1-month LIBOR + 18 bp floater. At that point, both the AS floater and the swapped A2 would have equivalent short duration. There would be other notable differences:
- The coupon on the swapped A2 could go negative if 1-month LIBOR ever dropped more than 18 bp below zero, while the coupon on the AS is floored at the current 25 bp margin
- The AS classes, backed by floating-rate loans, historically prepay much faster than the fixed-rate loans backing A2 classes, leading to a weighted average life on AS classes of less than four years; compared to the roughly 10-year weighted average life of A2 classes, AS involve less spread duration
- And swapping the A2 class does involve more operational risk and accounting complexity
The swapped A2 then looks rich on spread to the floating-rate AS. But it is important to consider the SOFR index.
Exhibit 2: Recent spreads at pricing of Freddie Mac fixed-rate K-deals
Note: All deals shown have 10-year collateral. The A1 class has an average WAL of 6.8 years while the A2 class has an average WAL of 9.8 years.
Source: Bloomberg, Amherst Pierpont Securities
SOFR has dropped to 1 bp since March 11, dragging the 30-day average most recently to 1.1 bp. The low SOFR rate reflects a tsunami of cash in the money markets, likely to persist as long as QE and fiscal stimulus continues. Adding the SOFR 30-day index to the AS class’s 25 bp margin produces a current coupon of 26.1 bp (Exhibit 3). Swapping the A2 class to 1-month LIBOR, with that index at 11 bp, produces a current coupon of 29 bp.
It is worth noting that both K-Series AS and swapped A2 classes offer much higher coupons that FHLBank’s longest SOFR floater, a 2-year, at S + 4 bp. The higher coupons reflect clear differences in spread duration, liquidity and prepayment risk.
Exhibit 3: Some benchmarks for value in agency floating-rate assets
Note: *Based on historical annual prepayment rates in Year 1 through Year 7 in Freddie Mac K-Series floating-rate deals; market levels as of 6 Apr 2021 market close.
Source: Amherst Pierpont Securities
Over time, both SOFR and 1-month LIBOR will vary. Sometimes SOFR coupons should run nominally higher than LIBOR coupons, other times not. When 1-month LIBOR transitions to SOFR on June 30, 2023, the Alternative Reference Rate Committee recently announced it will become 30-day SOFR + 11.448 bp. If that happened today, the swapped A2 coupon would become 1.1 bp + 11.448 bp + 18 bp for a current coupon of 30.548 bp, still slightly higher than the current 26.1 bp coupon on an AS class at SOFR + 25 bp.
The immediate issue for bank investors in particular is whether the current extra coupon in a swapped A2 class is worth the risk of no floor on the coupon, a longer weighted average life and spread duration and the added operational risk and accounting complexity. The AS class coupon is floored at the pricing margin, the swapped A2 is not. The AS is roughly a 4-year or shorter spread duration while the swapped A2 is more than nine years. The bank has to put the swap on and monitor effectiveness, running a small risk of ineffectiveness along the way. Selling the position will involve unwinding the swap at the same time, adding a small drag to liquidity. There’s regular auditor review.
Looking at current levels on K-Series SOFR floaters relative to comparable fixed classes, the floaters look at least like fair value if not inexpensive after weighing the value of the coupon floor and the shorter average life. From an operating perspective, floaters clearly look like an easier choice.
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