By the Numbers
A total return opportunity in Freddie Mac’s WI program
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.
Freddie Mac’s when-issued program for K-deals, launched last fall, looks like an interesting opportunity for total return investors. The WI certificates trade at wider spreads than traditional K classes, partly reflecting the flexibility that Freddie Mac has in determining the final pool of loans along with slow uptake so far by banks and other factors. When the WI certificates become eligible 90 days after issue for exchange into traditional K classes, the WIs should tighten to the Ks. A strategy of buying the WI at issue and selling when it becomes eligible for exchange could generate excess return in a portfolio of agency CMBS.
WI program structure
These WI certificates are issued for particular classes of K-deals up to 90 days prior to the deal being issued. Unlike traditional forward contracts, investors receive fixed monthly coupon payments guaranteed by Freddie Mac on the WI certificates before the reference deal is issued. Investors have the option of exchanging the WI certificates pro rata for the related class of K-deal pass-through securities any time after the deal settles. After settlement the class coupon of the K-deal is passed through to the WI certificates (Exhibit 1). Similar to when-issued Treasury securities, the K-deal WIs are tradeable and eligible for repo financing like regular securities.
Exhibit 1: Hypothetical WI K-deal timeline
Source: Freddie Mac When-Issued K-Deal Program Overview, page 4.
The upside of the program for Freddie Mac is that it lowers the interest rate and credit risk of warehousing the loans while the collateral pool is still being assembled. The upside for investors is that it offers a funded way to purchase K-deal certificates up to 90 days prior to deal settlement. Since the collateral is not yet identified, investors have to make decisions based on the general pool parameters defined in the offering documents. These parameters are typically somewhat broader and looser than historical average K-deals (Exhibit 2).
Exhibit 2: Typical pool parameters
Note: 1 The typical pool parameters for any particular deal may differ from the pool parameters outlined above. 2 Future collateral characteristics may differ from historical averages.
Source: Freddie Mac When-Issued K-Deal Program Overview, page 7.
The slightly wider range of collateral specifications and flexibility of the deal issuance window have contributed to a widening of spreads at pricing of the WIs versus the standard K-deal securities (Exhibit 3). The initial launch of the program in September seemed to be reasonably well digested, with the first WI K132 AM class pricing at 27 bp over swaps, just 1 bp back of the FHMS K131 AM issued two weeks before. Three WI AM classes for K133, K134 and K135 deals all priced at 25 bp over swaps in October.
Exhibit 3: Spreads at pricing of standard and WI classes of 10-year, fixed-rate K-deals
Note: As of December 2021 most classes of K-deals began to be priced off the SOFR swaps curve using P-spreads. These P-spreads have been converted to spreads versus the LIBOR swaps curve (N-spreads). Data through 2/16/2022.
Source: Bloomberg, Amherst Pierpont Securities
As spreads began to widen in November, the WI AM classes began to price wide of 10/9.5 DUS (Exhibit 4). Initially, the spread between FHMS A2s and DUS remained fairly stable with 10/9.5 pricing 5 bp to 7 bp back. That changed in late January when the WI program expanded to include the A2 class. The first WI A2 to price was the WI K140 A2 which came at LIBOR swaps + 35 bp on January 26 this year. The WI K140 AM priced at the same time at LIBOR swaps + 44 bp, or 9 bp back of the WI A2. Through late January into mid-February, spreads continued to widen and DUS 10/9.5 were pricing in-line with the WI A2s and inside of the WI AMs.
Exhibit 4: Pricing spread of Freddie Ks compared to Fannie Mae DUS
Source: Bloomberg, Amherst Pierpont Securities
Multiple factors could be contributing to the additional pressure on WI Ks:
- As the market sold off many investors have pulled away from longer duration securities, particularly bank and insurance companies with mortgage portfolios that are extending.
- Banks, who have traditionally been among the heaviest investors in A2s, have often faced additional hurdles to get approval to buy and trade the WI certificates.
- Other portfolios are limited to securities with durations under 10 years. The WI AMs typically have an assumed weighted average life of 10.25 years at pricing, which would make them ineligible investments.
- To complicate things further, K-deals began pricing off of the SOFR swaps curve in 2022 using P-spreads, as opposed to off of the LIBOR swaps curve using N-spreads. It’s simple to make the conversion, but it does add another wrinkle into a newly introduced product in a volatile market.
Money managers have stepped in as the largest buyers of some of the first WI AM classes of K-deals (Exhibit 5). It isn’t clear yet how much trading of the WIs is occurring prior to deal settlement, but it seems probable that some investors intend to capture the additional premium of the WIs and sell them after the WI certificates are eligible to be exchanged for securities. Tightening of only a few basis points on an instrument with a spread duration of more than nine years can quickly add up, and the regular cycle of WI issuance could give a total return portfolio a steady set of opportunities to recycle the trade
Exhibit 5: Breakdown of investors for WI K135 class AM (priced October 26, 2021)
Note: The breakdown of the investors is as of the closing date.
Source: Freddie Mac When-Issued K-Deal Program Overview, page 9.
Complete program details can be found in this WI investor presentation and WI FAQ, published by Freddie Mac.
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.