By the Numbers
Prepayment and defeasance lessons from the last Fed hiking cycle
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.
Freddie Mac has announced plans for its first 5-year fixed-rate K deal since January 2016, and history may have some useful lessons. The 2016 deal came after the Fed started hiking in late 2015. But once the hiking cycle peaked and long rates started to fall in early 2019, prepayment and defeasance activity surged including among borrowers in the 2016 deal. If a similar dynamic prevails in the upcoming deal, investors should assume prepayment and defeasance rates could begin to rise as early as mid-2024, putting some modest downward pressure on projected yields.
Freddie Mac has issued four previous 5-year K deals, with the most recent being the FHMS K-504 deal, which priced and settled in January 2016. The Fed hiked rates in December of 2015 from 25 bp to 50 bp, its first hike since the 2008 start of the Great Financial Crisis. At the time of issuance, the weighted average loan age of the collateral in the K-504 deal was 11 months (Exhibit 1).
- The original weighted average life (WAL) of the A1 class was 3 years with a final maturity – assuming no prepayments – of 3.75 years; however, the class paid off in 2.5 years.
Exhibit 1: Principal and interest classes of FHMS K504 deal
Source: Bloomberg, Santander US Capital Markets
- The original WAL of the A2 class was four years, and the bond paid off only 1 month prior to its final maturity date. However, nearly 40% of the collateral had prepaid prior to maturity (Exhibit 2), and 50% had been defeased by early 2020.
In the FHMS K504 deal, at least 40% of the loans had yield maintenance penalties, while half were subject to defeasance (Exhibit 2). Both prepayments via yield maintenance and defeasance can lower the expected yield for the principal and interest classes (A1 and A2), even for Freddie K-deals, which tend to be much more bullet-like than DUS or Ginnie Mae project loans.
Exhibit 2: Prepayments and defeasance of FHMS 504 deal
Source: Bloomberg, Santander US Capital Markets
Defeasance does not affect the performance of the securities nearly as much as prepayments. That is one of the reasons Freddie Mac has migrated more towards requiring defeasance for loans in their K-deals. Borrowers have the option of paying a fee at origination that would allow them to defease the loan up to the beginning of the open period, which is typically 3 months prior to maturity, as opposed to defeasing the loan through maturity. In practice, only a tiny percentage of borrowers pay that fee, so loans are nearly always defeased to final maturity. This protects the expected returns for the investor.
Loans that are subject to yield maintenance can prepay without penalty during the open period, and can prepay prior to the open period by paying the greater of the yield maintenance penalty or 1% of the outstanding balance. This can reduce the yield for investors in the principal and interest classes as the outstanding balance declines. The penalties are typically distributed to the B-piece buyers and the interest only classes, depending on the deal.
In the K504 deal the percentage of collateral that is defeased peaks just above 50% in early 2020, then falls to zero after May 2020, as the defeased loans are paid off at their final maturity date. The rates of prepayments and defeasance in the deal began to climb in early 2019, which was just as the Fed hit the peak of their rate hiking cycle, lifting rates to 2.50% in December 2018. Longer-term Treasury rates peaked just above 3.00% in November of 2018, then began to fall as volatility subsided and the hiking cycle came to an end (Exhibit 3).
Exhibit 3: Rate environment for last 5-year fixed-rate K deal
Source: Bloomberg, Santander US Capital Markets
Through the first half of 2019 rates rallied 150 bp, setting off a wave of refinance activity. The percentage of collateral in the K504 deal that was either prepaid or defeased climbed from 10% in early 2019 to over 80% by year-end.
It is unclear yet what the mix of loans subject to yield maintenance or defeasance will be in the new K505 deal. Investors should run the deal assuming fast prepayment speeds beginning in late 2024 for yield maintenance loans once they hit the open period, and that defeasance loans pay off at maturity. The impact on projected returns should be modest, but it will likely lower yields by a few basis points.
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