By the Numbers
The value of SOFR ARM tails
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.
Investors in hybrid ARM MBS pools often try to value the fixed- and floating-rate cash flows from the pools separately. Many investors will calculate yields by assigning prepayment speeds during the fixed-rate period and assume the floating rate portion or tail will later sell for a certain dollar price. Many potential buyers of newly issued hybrid ARM pools wonder how much value the tail contributes to the whole bond, but it turns out the tail often contributes less than 10%.
Hybrid ARMs reset at large margins over the index rate, and this margin implies that the tail should trade at a premium to par. The value of the tail therefore depends on prepayment speeds during the floating rate period—faster speeds will reduce the premium. The present value of the tail also depends on how much of the pool remains after the fixed-rate period. Faster prepayments during the fixed-rate period will lower the present value of the tail.
There is an active secondary market for hybrid ARM tails from pools that have seasoned past their fixed-rate period. These pools have recently traded at roughly 1.5 bp OAS using Yield Book’s model. This OAS can be used to calculate the future price of the tail (Exhibit 1). This uses a recently issued hybrid ARM pool, FN BT7242, which has a 7-year fixed-rate period followed by semiannual resets to SOFR + 2.37%. The price at a 7-year horizon is $102-21 assuming the forward curve is realized, and the model predicts 7.74% of the pool will remain at the horizon. All data is run as of August 23 to be consistent with an earlier article on hybrid ARM relative value.
Exhibit 1. Present value of hybrid ARM tail premium
Run as of 8/23/2021 using Yield Book’s v21.7 prepayment model. The base case (0 bp) scenario assumes the forward curve is realized. Other scenarios assume a parallel shift away from the base case forward curve.
Source: Yield Book, Amherst Pierpont Securities
In the base case, the tail accounts for 7.2% of the total present value of the pool, and the remaining 92.5% of the market value comes from cash flows in the 84-month fixed-rate period. The table also shows the value of the tail in various interest rate scenarios. The tail contributes less value to the pool in lower interest rate scenarios since prepayments during the fixed-rate period accelerate so even less of the pool remains. And the tail contributes more value in the higher rate scenarios since prepayments slow. However, prepayment speeds tend to accelerate more in lower interest rate scenarios than they slow in higher rate scenarios. Therefore, the present value of the tail falls more in lower-rate scenarios than it increases in higher-rate scenarios. For example, if rates fall 50 bp the tail only contributes 3.8% of the market value of the pool, which is 3.4% below the base case. But if rates increase 50 bp then the tail contributes 9.6% of market value, which is 2.6% higher. This helps limit the tails contribution to total pool value. Even if rates increase 200 bp more than the forward curve implies, the tail is only worth 12.6% of the current market value of the pool.
The assumption about the future value of the tail does not have much effect on the present value of the tail since most of the pool pays off before the floating rate period (Exhibit 2). This table shows three scenarios, each run to the forward curve but assuming the tail’s OAS, and therefore future price, is different. The tail’s contribution to the value of the pool only changes ±5 bp even though the future value varies roughly ±$0-23.
Exhibit 2. Sensitivity to tail OAS
Run as of 8/23/2021 using Yield Book’s v21.7 prepayment model.
Source: Yield Book, Amherst Pierpont Securities
Investors should not need to worry much about tail values when analyzing pools of newly originated loans. And the tail contributes even less to pools with longer fixed-rate periods (pools with shorter fixed-rate periods are no longer common). Prepayments during the fixed-rate period ensure the tail will be small, even if interest rates increase much faster than implied by the forward curve. And the tail trades at a large margin to SOFR, which means it will almost always trade above par unless there is massive spread widening.
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