By the Numbers
Create synthetic DUS floaters for higher yield
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 CMBS and other assets have been buying floating-rate debt and shortening duration as the market has pulled forward expectations for a Fed lift off, with at least two rate hikes now priced in for 2022. The increased demand has tightened spreads on Freddie K floaters and other short CMBS while longer maturity DUS spreads remain sticky at wider levels. For banks able to do last-of-layer hedging, buying fixed-rate DUS and selling matched-maturity SOFR swaps creates synthetic SOFR floaters with significantly higher coupons than Freddie K floaters.
A steep term structure
The DUS term structure has been steepening over the past few weeks as investors have piled into shorter duration and floating rate instruments (Exhibit 1). In the short end, spreads for DUS 5/4.5 have nearly returned to the early June tights in the very low single digits when pools were issued 2 bp to 3 bp over the LIBOR swap curve. The longer end of the DUS term structure began widening in early June and has been trading in a sticky range, with 15/14.5 spreads hovering around 50 bp over LIBOR swaps and 10/9.5s about half of that at 25 bp to 28 bp.
Exhibit 1: DUS spreads have steepened across the term structure
Source: Bloomberg, Amherst Pierpont Securities
The spread curve in Freddie Mac CMBS also has broadly steepened. The A2 classes of standard 10-year Freddie K deals reached a tight of 10 bp over LIBOR swaps in early June and have since widened to 18 bp, but they haven’t been above 20 bp since the first 2021 deal priced in January with the A2 at LIBOR swaps + 21 bp (Exhibit 2). Spreads of the shorter A1 classes are hovering around the single digit mark over LIBOR swaps, hardly budging from the historical tight of 6 bp that they reached in March of 2021. Floating rate A and AS classes have discount margins that are also at or through their historical tights of SOFR + 19 bp to 20 bp.
Exhibit 2: Freddie Mac K spreads have also roughly steepened
Note: Data as of 11/4/2021. Spread for AS floating rate classes represents the fixed spread to the underlying LIBOR or SOFR benchmark rate.
Source: Bloomberg, Amherst Pierpont Securities
DUS pools typically trade a few basis points wide of standard Freddie K classes with similar duration, but that difference has become sticky and somewhat pronounced. DUS 10/9.5s have been trading 8 bp to 12 bp back of Freddie K 10-year A2 classes for weeks, with recent pools coming at LIBOR swaps + 28 bp for a 1.84% fixed coupon (Exhibit 3).
Agency floaters don’t offer much yield
In this rate environment investors are naturally a bit wary of extending duration, despite the additional yield offered out the term structure. Heavy floater issuance this year has kept that market deep and liquid, and demand has increased as investors look to temper interest rate risk, keeping pressure on spreads. A recently issued 10-year Freddie K floating rate deal, the FHMS K-F122, priced with a floating spread of SOFR + 19 bp. Thirty-day compound average SOFR is currently at 5 bp, giving the AS class an initial coupon of 24 bp.
Exhibit 3: Pairing DUS with SOFR swaps creates attractive synthetic floaters
Note: Indicative levels only. Data as of 11/4/2021.
Source: Bloomberg, Amherst Pierpont Securities
A better option than accepting low coupon floaters in KF deals is to create a synthetic floater using a similar maturity DUS and overlaying a SOFR swap. An investor can buy the 10/9.5 DUS with a 1.84% coupon and pay fixed in a 10-year SOFR swap with a 1.30% rate, creating a synthetic SOFR floater with a coupon of 30-day SOFR + 54 bp (Exhibit 3). In fact, buying any term DUS and swapping it will leave an investor with a higher coupon synthetic floater than the FHMS K-F122 AS with a coupon of 30-day SOFR + 19 bp. The best yield pick-up is offered out the curve with a synthetic 15/14.5 which picks up 78 bp over 30-day SOFR.
Exhibit 4: SOFR swap to match a 10/9.5 DUS
Note: Data as of 11/4/2021.
The approximate dollar duration of the 10-year pay-fixed SOFR swap is -$9,400 per $10 million notional, or -9.4% of face, matching the approximate duration of the 10/9.5 DUS pool (Exhibit 4). The fixed coupon of 1.85% and floating rate coupon of 30-day SOFR + 54 bp creates a zero-premium swap, which matches the creation of the synthetic floater. Banks should be able to get hedge accounting treatment for CMBS swapped using at-the-market levels and relying on last-of-layer treatment. Banks alternatively should be able to get hedge accounting treatment using an off-market swap that matches the CMBS coupon and other cash flows and relies on short-cut hedge treatment. Either approach to swapping should create a synthetic floater that adds substantially to portfolio income relative to levels available in the cash CMBS floater market.
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