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.
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.
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.
Copyright © 2023 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.