By the Numbers
Framing relative value in hybrid ARMs
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.
MBS investors looking for short duration may find value in hybrid ARM pools. The Fannie Mae and Freddie Mac transition to loans indexed to SOFR in late 2020 disrupted ARM supply, leading to a temporary drop in origination early this year. But production has rebounded lately, pushing ARM spreads wider. Hybrid ARM pools offer better yield and OAS than 15-year fixed-rate pools with similar duration. And hybrid ARMs currently offer better projected 1-year total return unless rates fall more than 100 bp.
Disruption in ARM supply
The transition from LIBOR- to SOFR-indexed hybrid ARMs disrupted supply for much of the past year. Both GSEs stopped acquiring LIBOR-indexed ARMs at the end of 2020 and would only acquire loans started before October 2020. This led to a sharp drop in supply from November 2020 through May 2021 (Exhibit 1). But production rebounded in June as originators began originating SOFR-indexed ARMs. Supply has topped $1 billion for each of the last three months. From 2019 through October 2020 supply averaged roughly $750 million a month and only exceeded $1 billion three times. Demand may also be lower for the new ARM pools since some investors may not have approval to buy pools indexed to SOFR.
Exhibit 1. Hybrid ARM supply has bounced back after plunging in late 2020
Source: Yield Book, Amherst Pierpont Securities
Spread and projected return relative to 15-year MBS
The sharp rebound in supply has pushed ARM spreads wider, and pools appear to offer relative value compared to 15-year MBS (Exhibit 2A). The exhibit compares two trades. The first is a 7/6 SOFR hybrid ARM—the loans pay a fixed rate for seven years, after which the loans reset every six months to SOFR + 2.37%. The weighted average coupon is currently 1.77%; although the loans’ coupons will not adjust for nearly seven years, the average coupon can change when loans prepay. The comparison trade is a duration- and proceeds-neutral combination of 15-year MBS and cash. The ARM pool offers higher yield and OAS than the 15-year position.
Exhibit 2a. A 7/6 SOFR ARM offers higher yield and OAS than 15-year 2% MBS
Note: All market levels as of 8/23/21 market close. Using Yield Book’s v21.7 prepayment model.
Source: Yield Book, Amherst Pierpont Securities
The ARM pool is somewhat more negatively convex than the 15-year trade. A 12-month total return profile sheds some light on this (Exhibit 2b). In the base case, the ARM is projected to return 0.35% more than the 15-year trade. The ARM does slightly better if rates increase but worsens if rates fall. However, the total return stays above the total return on the 15-year trade even if rates drop 100 bp.
Exhibit 2b. The ARM pool offers better one-year total returns in various rate scenarios
Note: All market levels as of 8/23/21 market close Using Yield Book’s v21.7 prepayment model. Interest rates shift linearly to the one-year horizon. Reinvestment at 1-month Treasury rates. Horizon repricing at constant OAS.
Source: Yield Book, Amherst Pierpont Securities
There are some caveats to consider. Investors that can roll their TBA positions may be able to take advantage of special dollar roll financing, which increases the value of the 15-year position. But not all investors can dollar roll. Another consideration is that the ARM market is less liquid than that for 15-year MBS, and ARMs are not included in the Bloomberg Barclays Index. Therefore, ARMs ought to trade at a spread concession to 15-year MBS. But there is little historical data available to measure the typical amount of that concession. Finally, the SOFR index, unlike LIBOR, does not incorporate a credit component. Investors should not expect the SOFR coupon to reset higher in a period of credit stress.
Another consideration is that the example pool is serviced by Quicken. However, a lot of recent production came from Quicken and loanDepot, and relatively less from Wells Fargo and Chase. But the two bank’s loans typically have initial note rates that are 15 bp to 20 bp higher than the non-bank loans, which adds some prepayment risk to those loans.
Value relative to PACs
It is also useful to compare the ARM pool to other mortgage products that do not have the same liquidity advantage as 15-year MBS. The first is a short PAC backed by jumbo 2.5% pools and pays a 1.5% coupon (Exhibits 3a and 3b). The static yield of the ARM is 10 bp lower than that of the CMO, but the ARM pool’s OAS is 22 bp higher. The ARM position is more negatively convex than the CMO, underperforming in a rally but outperforming in a sell-off. The choice may depend on an investor’s view of future interest rates.
Exhibit 3a. Value comparison of a 7/6 SOFR ARM to a short CMO PAC
Note: All market levels as of 8/23/21 market close. Using Yield Book’s v21.7 prepayment model.
Source: Yield Book, Amherst Pierpont Securities
Exhibit 3b. Total return comparison of a 7/6 SOFR ARM to a short CMO PAC
Note: All market levels as of 8/23/21 market close Using Yield Book’s v21.7 prepayment model. Interest rates shift linearly to the one-year horizon. Reinvestment at 1-month Treasury rates. Horizon repricing at constant OAS.
Source: Yield Book, Amherst Pierpont Securities
When evaluating the CMO investors should also consider that the PAC bands could narrow if interest rates drop and prepayment speeds increase. The CMO is likely to trade wider if that happens. However, the total return scenarios assume a constant OAS and therefore likely overstate the value of the CMO in a rally.
Value relative to agency CMBS
Fixed rate Freddie CMBS are another short-duration asset that investors use as an alternative to 15-year MBS and are a useful comparison to the ARM pool (Exhibits 4a and 4b). The results are mixed—the ARM pool offers a higher static yield but has more negative convexity and a lower OAS. The total return profile shows that the ARM outperforms if rates remain relatively range bound, but the CMBS outperforms in a rally or a larger sell-off. Once again, the choice may come down to an investor’s view of future interest rate risk.
Exhibit 4a. Value comparison of a 7/6 SOFR ARM to a short fixed-rate Freddie CMBS
Note: All market levels as of 8/23/21 market close. Using Yield Book’s v21.7 prepayment model.
Source: Yield Book, Amherst Pierpont Securities
Exhibit 4b. Total return comparison of a 7/6 SOFR ARM to a short fixed-rate Freddie CMBS
Note: All market levels as of 8/23/21 market close Using Yield Book’s v21.7 prepayment model. Interest rates shift linearly to the one-year horizon. Reinvestment at 1-month Treasury rates. Horizon repricing at constant OAS.
Source: Yield Book, Amherst Pierpont Securities
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2026 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
