By the Numbers
Yield maintenance can make DUS investors more than whole
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.
Prepayments in agency CMBS have jumped over the past year, with the fastest speeds coming in loans with low or no prepayment penalties. But prepayments have accelerated even in loans subject to defeasance and yield maintenance, which in theory removes the interest rate incentive to refinance. Most Fannie Mae DUS investors appear to have substantially come out ahead, at least on market value. A random sample of DUS loans that prepaid during the yield maintenance period shows the penalties typically added several points to the value of the bond.
Yield maintenance is designed to make investors a little bit better than whole by charging the borrower a premium equal to the present value of the remaining payments on the loan discounted at Treasury rates. By discounting the cash flows at lower Treasury rates instead of agency mortgage rates, the present value of the penalty rises, and the cash returned to the investor should exceed the fair market value of the bond. When the premium is passed through to the investor along with prepaid principal, investors working for total return should be at least indifferent to voluntary prepayments; they have been paid the full market value of the loan and should be able to reinvest and replicate the repaid cash flows. In practice this is typically true. A random sample of Fannie Mae DUS loans that prepaid with yield maintenance penalties over the past two years can help make the point (Exhibit 1). The estimated market value around the time the loan terminated is, in all but one case, below the value of par plus the penalty premium. The excess return to the investor—the premium over the estimated market value—ranges from 0.45% to 14.9% of the principal balance.
Exhibit 1: Analysis of yield maintenance payments of Fannie Mae DUS loans
Note: The last pricing date is the last date a price was calculated for the bond on Bloomberg. The last price is from Bloomberg’s BVAL model. The security termination date listed in Fannie Mae’s DUS disclose data is the first day of the month when the final cashflow is paid.
Source: Fannie Mae, Bloomberg, Amherst Pierpont Securities
The lone exception in this sample is the AN5515 pool, which had an estimated market value of $103.97 on April 6, 2020. The bond’s penalty was 2.9% of the remaining principal balance, making the combined principal + interest + penalty payments about 0.80 below that market value. But here’s the thing – the bond usually terminates on the first of the month when the payment is due, but the borrower can choose to prepay the loan anytime during the month. In March of 2020 it was really early days of the pandemic and the markets were wildly volatile. The constant maturity Treasury (CMT) rate used in the yield maintenance calculation is set as the 25th business day prior to the intended prepayment date. This loan has a prepayment date of 3/16/2020, so the rate used to calculate the yield maintenance premium is the 2-year CMT rate from 2/10/2020 (because the loan had 2 years remaining to the end of the yield maintenance period). The 2-year Treasury rate was about 1.40% on 2/10/2020 and had dropped to 0.36% by 3/16/2020 when the loan prepaid and the financial markets close to peak panic stations. On 2/10/2020 the market value of that loan was 102.48, and the 2.9% yield maintenance premium would have covered the full market value plus about 0.40%.
This can potentially be a risk for investors. There is 25-day lookback period used to set the CMT rate for calculating the payoff, plus an approximately 1-month lag between when the loan is paid off and the cash is received by the investor. When markets are volatile, it is possible that the extra cushion of return provided by Treasury discounting may not fully compensate for a change in market value. This is also more likely to occur when the remaining term of yield maintenance is rather short and the value of the penalty has declined.
The formulas that Fannie Mae uses for the calculation of yield maintenance premiums can be found in Celebrating 30 Years of the Fannie Mae DUS Program (page 8).
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