By the Numbers

Weighing value across CMO floaters and CLO ‘AAA’

| January 17, 2025

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.

The nominal spread difference between agency CMO floaters and new CLO ‘AAA’ debt has dropped to its lowest level in at least a year if not more. That has opened the door to portfolios looking to move from CLOs to CMO floaters. For portfolios that value the capital and liquidity treatment of CMO floaters in exchange for a limited reduction in current income, the timing seems good.

Primary spreads across the spectrum of structured products have ground tighter through the first two weeks of the new year while agency MBS spreads have widened. The counter directional move in exposures has skewed relative value in favor of agency MBS and CMO floaters appear to offer attractive relative value versus CLO ‘AAA’s, particularly for domestic depositories.

CMO floaters near parity with ‘AAA’ CLOs

Historically, CLOs have traded wide to comparable floating rate exposures and last year was no different despite a steady grind tighter. On average, CLO ‘AAA’s offered an additional 40 bp of discount margin versus 7.0% cap CMO floaters backed by Fannie Mae or Freddie Mac collateral over the course of last year. That basis has converged to almost zero with both 7.0% cap conventional floaters and new issue CLOs trading at roughly 120 DM (Exhibit 1).

Exhibit 1: CMO floater, CLO spreads converge

Source: Santander US Capital, eMBS, Black Knight, Intex Solutions Note: Agency CMO spreads are calculated using a simple average margin on all deals printed per observation month for each cohort and cap. CLOs spreads are represented as a simple monthly average of daily spreads.

Admittedly, the two instruments are not perfect proxies for one another. Both instruments carry comparable spread durations of roughly five years. However, CLOs benefit from being uncapped and trading to a modestly shorter interest rate duration than CMO strip floaters. Newly minted CLO ‘AAA’s trade to roughly a 0.25-year interest rate duration given the fact they are quarterly reset uncapped floaters. By comparison 7.0% cap conventional CMO floaters carry effective durations of roughly 0.35 years, slightly longer than the CLO but subject to change given both the absolute level of rates and the shape of the forward curve.

Additionally, some portion of the spread that the floater buyer is being paid is premium being passed through to that investor for shorting a cap. Valuing an 8-year, 7.0% bullet cap on SOFR30A, which roughly aligns with the cash flow and structure of the floater absent amortization and prepayments, yields a premium of 132 bp or roughly 16 bp per annum when amortizing the premium over the life of the cap. This suggests that the uncapped CMO floater would likely trade roughly 15-20 bp tighter than the CLO.

CMO spreads stay wide in the face of lower SOFR but a steeper curve

CMO floater spreads have held steady even though the SOFR index has dropped. Since the end of August, 1-month SOFR has fallen from 5.20% to 4.30% (Exhibit 2). That lowers the immediate risk that the CMO floater coupon will hit the cap and become fixed. Since the end of August, rate volatility implied in the options market has also dropped slightly, further lowering risk that SOFR hits the cap. Lower risk should translate into a lower margin. However, another important factor has changed: as 1-month SOFR has dropped, the SOFR yield curve has steepened. The spread between 1-month SOFR and 5-year SOFR has gone from -180 bp inverted to the neighborhood of flat (Exhibit 3). The steepening curve means implied forward 1-month SOFR has moved up substantially, raising the risk that the floater could get capped in the future. These changes in SOFR look like they have roughly offset one another, at least based on CMO floater spreads.

Exhibits 2 and 3: Lower spot SOFR but a steeper forward SOFR curve

Source: Santander Capital Markets, Bloomberg LP

The call on relative value in the CMO floaters depends on the weight attached to lower risk today and the weight attached to higher risk forward. For investors that give more weight to current circumstance, the floaters have more value than they did in the first half of 2024.

The tightening of the basis between the two instruments should still be a catalyst for certain buyers, particularly domestic depositories, to skew purchases away from structure and into agency floating rate product. While the revaluation of the two instruments to account for the cap suggests that the CLO ‘AAA’ may still offer better value than the CMO, this is likely not substantive enough compensation for depositories to forego the ancillary benefits associated with investing in agency MBS versus private label product, namely the ability to pledge agency MBS for regulatory liquidity under the Liquidity Coverage Ratio framework as well as the actual liquidity associated with the ability to pledge agency MBS to the Federal Home Loan Bank system. And despite conventional MBS and ‘AAA’ structured products generally carrying the same risk-based capital requirement, structured products are much more stress test capital intensive assets.

One additional consideration for all portfolios, particularly levered ones, is the significant financing advantage that agency CMOs carry versus CLOs. CLOs require roughly three times the amount of equity haircut for the same market value as portfolio of CMOs. And funding spreads are roughly double those of CMOs as well (Exhibit 4). As the spreads on the two instruments converge, particularly at tighter levels, levered players may look to increase exposure to CMOs.

Exhibit 4: Funding haircuts and margins for CMOs and CLOs

Source: Santander US Capital Markets

Chris Helwig
christopher.helwig@santander.us
1 (646) 776-7872

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