By the Numbers

Understanding agency CMO mountain floaters

Chris Helwig | March 7, 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.

In response to high demand for floating-rate MBS from both domestic depositories and asset managers, a relatively novel CMO class has started showing up in agency structures. These bonds, commonly referred to as mountain floaters, have worked for both investors and CMO desks. They offer investors a higher margin over a floating index in exchange for the embedded sale of multiple interest rate caps struck at higher rates. They also give CMO desks an alternative to creating coupon-stripped, fixed-rate CMOs to meet demand for traditional floaters.

Mountain floaters have existed for some time but are popping up with increasing frequency in CMO structures, likely due to a handful of reasons. Investors who are reluctant to add fixed-rate exposure but are looking to protect current income if rates drop can use mountain floaters as a high-carry, short-duration portfolio exposure. Depending on structure, mountain floaters can offer roughly three times the stated margin of traditional floaters (Exhibit 1).

Exhibit 1: Comparing coupons of mountain and traditional floaters

Source: Santander US Capital Markets, Bloomberg LP

Like a traditional agency CMO floater, the coupon on a mountain floater rises with the SOFR30A index up to a maximum or cap. But unlike a traditional floater, where the coupon stays at the cap if the index continues to rise, the coupon on a mountain floater declines. If the index rises high enough, the coupon on some mountain floaters can drop to zero.

In return for the risk of a lower coupon as the index rises, a mountain floater pays a much higher margin than a traditional floater. An investor can think of this margin as the premium for selling multiple interest rate caps. Simply selling caps on a 1:1 basis wouldn’t generate adequate premium to support the coupon on the mountain floater. Depending on the ratio of mountain floaters to traditional floaters in a deal, mountain floater buyers will ‘sell’ multiples of the notional of their bond to generate the stated margin on their bonds. This structural leverage can come at cost though, as a bond’s coupon declines rapidly in the ‘corridor’ of SOFR strikes that the mountain floater buyer is short and can eventually go to zero. Conversely, traditional capped CMO floaters will offer a much more stable profile, albeit with substantially less carry and yield.

Portfolio applications

The most obvious application for mountain floaters is for portfolios that are looking to take a view on lower front end benchmark rates but that are not able to do so through the options market, where they could extract both up-front premiums and mark-to-market gains by shorting options on the same SOFR strikes as the mountain floater. The most likely home for these bonds may be mutual funds whose investment covenants do not allow them to take leverage through the options market. One potential sticking point for asset managers is that while these bonds generally model to short effective durations, the embedded structural leverage may create poor price convexity.

Given the same nominal amount of rate change from spot benchmark rates, these profiles will likely exhibit a substantially greater decline in price in a rising rate environment than price appreciation given a declining one. Furthermore, premium dollar prices on many of these profiles will compress spreads to faster speeds while higher rates and slower speeds could expose more of the cash flow to potential coupon declines, potentially making the overall return profile of the asset fairly whippy. Mark-to-market investors will likely weigh whether they are being adequately compensated in the form of current carry for potential mark-to-market volatility.

Depositories may find the profile attractive as well as there are likely other assets on balance sheet that may more than offset the performance of the mountain floater given a protracted rise in rates. With that said, the fact that the bonds’ coupon can go to zero may be problematic for depositories as they could be reclassified as a non-performing asset that would require substantially more risk-based capital to support it. If the asset class does garner traction with depositories, further evolution of the structure would likely include a floor or stub coupon to avoid this reclassification.

Many ways to create CMO floaters…

Depending on the shape of demand for floating rate investments, CMO desks may have some optionality with regards to how they choose to satisfy that demand, specifically what cash flows may be created with the residual interest, principal or both after creating the floating-rate bond. In its simplest form, a floating rate CMO can be created by paying 100% of the principal and scheduled interest based on a simple formula of a benchmark rate plus a stated margin, capped at the fixed-rate collateral coupon. All residual interest is paid to a notional interest-only class, commonly referred to as an inverse IO. For example, $100 million of 7.0% fixed-rate collateral can be structured into $100 million of a 7.0% cap floater that pays a coupon of SOFR30A +100 bp and $100 million notional of an inverse IO with a 6.0% strike, which is simply the maximum coupon the inverse IO can receive if the index goes to zero, calculated as the difference of the floating rate cap and the margin.

Things can get a bit trickier when investors require caps greater than the underlying fixed-rate collateral. Using the same $100 million of 7.0% fixed-rate collateral, if the floater buyer wanted an 8.0% cap, the CMO desk could not print $100 million tranche as there may not be sufficient interest to pay the floater if the benchmark exceeds a certain value. In this instance, the CMO desk could create a ‘synthetic’ 8.0% pass through by reducing the notional of the floater and inverse IO to $87.5 million, calculated by dividing the 7.0% fixed-rate by the 8.0% cap.

CMO desks have other alternatives to create excess interest to pledge to floating-rate cash flows as well. In markets where there is more balanced demand for fixed and floating rate CMOs, desks can create par-priced or discounted fixed-rate bonds and pledge the difference in coupon between the fixed-rate CMO and the collateral to the floater and inverse IO components of the structure. Given the dearth of demand for fixed-rate, stripped coupon CMOs, dealers have been reluctant to position these bonds to print deals, enter the mountain floater.

The mountain floater structure and cash flow

FHR 5409 AM is an example of a mountain floater. Similar to the example above, the components include:

$90,562,500 of an 8.0% cap floater struck off 7.0% fixed-rate collateral which carries a stated margin of 85 bp and represents 87.5% of the notional principal (Class AF)
$12,937,500 of the mountain floater, which carries a cap of 8.4%, a stated margin of 245 bp and represents 12.5% of the notional principal (Class AM)
$103,500,00 of a 5.95% strike inverse IO, calculated as the difference between the cap and margin on the mountain floater. The balance of the IO represents 100% of the notional. (Class AS)

The mountain floater effectively works in conjunction with the inverse IO to support the coupon on the traditional floater. The inverse IO will contribute interest to pay the coupon on the class AF floater up to the 5.95% SOFR30A strike, at which point the IIO coupon goes to zero. Once the IIO coupon is floored, the mountain floater will begin to contribute interest to the floater as the benchmark rate continues to increase. The coupon on the mountain floater is floored at zero when the benchmark rate reaches 7.15%, the difference between the 8.0% cap and the 85 bp margin on the class AF floater.

Because of the structure, the mountain floater is effectively long the benchmark index up to a 5.95% strike, short the benchmark to a 7.15% strike and then long the index again once the coupon is floored at zero and cannot decline any further despite a continued rise in the benchmark rate. The bondholder is effectively short a SOFR ‘corridor’ between the 5.95% and 7.15% strikes.

Said another way, the investor is entitled to receive 245 bp over the benchmark up to the index rate of 5.95% on a 1:1 basis. However, if SOFR rises above the 5.95%, then the mountain floater’s coupon declines rapidly given the mismatch between the notional balances of the traditional and mountain floaters, which are effectively levered 7:1 (Exhibit 2). In this instance, the investor is selling a series of seven caps on SOFR between the corridor strikes. The investor is compensated for selling these options on these SOFR strikes through a stated margin that is roughly three times that of a traditional floater with a comparable cap structure.

Exhibit 2: FHR 5409 AM Coupon Formulas

Source: Santander US Capital Markets, Bloomberg LP

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

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