By the Numbers
A hot July for CMO issuance
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Dealers underwrote an estimated $35 billion of agency CMOs in July, one of the highest 1-month volumes in the past 15 years. Near record breaking CMO issuance is somewhat surprising given relatively tepid bank demand for MBS broadly and CMOs specifically. Weaker bank demand for CMOs apparently is being offset by heightened demand from mutual funds and hedge funds, likely in the form of floaters that continue to offer attractive relative value both as a levered carry trade and hedge-adjusted basis compared to pass-throughs.
Framing current issuance
CMO issuance is attempting to keep pace with the late July mercury readings as this month is shaping up to be one of the highest on record. July represents more of a continuation and escalation of a trend than an aberration as the first half of this year has been marked by elevated CMO issuance. When viewed both as a percentage of gross MBS issuance and in absolute amounts, a lot of CMOs are being dealt. Desks across the street have underwritten over $185 billion of bonds through the first six months of this year. First quarter issuance was $100 billion and represented a whopping 34.7% of gross pass-through issuance, by far the highest CMO share of issuance in the past five years (Exhibit 1). Admittedly, the CMO share was against seasonally depressed gross MBS issuance of less than $300 billion.
Exhibit 1: CMOs make up a growing amount of overall MBS issuance
Source: Santander US Capital Markets, Inside Mortgage Finance, Fannie Mae, Freddie Mac, Ginnie Mae
Bank demand
Historically, elevated CMO demand has been marked by a growing appetite from depositories as CMOs have been a useful tool for banks to manage the duration gap between their assets and liabilities. In the wake of the failure of Silicon Valley Bank and other depositories, many banks changed how they allocated assets to the investment portfolio, increasing exposure to both floating-rate MBS along with more positively convex instruments like Treasuries and agency CMBS that can be efficiently swapped to a shorter duration.
Measuring since the start of 2019, CMOs as a share of bank MBS holdings and total securities surged in 2020 as Covid-era monetary stimulus flooded bank balance sheets with deposits (Exhibit 2). These deposits, to a large degree, could not be offset by newly originated loans as lending standards tightened against a contracting economy, forcing banks increasingly into securities to defend their net interest margins.
Exhibit 2: CMO holdings surge then wane post COVID and SVB
Source: Santander US Capital Markets, S&P Capital IQ
CMOs subsequently have made up a smaller share of bank investment portfolios, holding fairly steady at roughly 15% of total MBS holdings and just over 7% of total securities. Admittedly, the bank holdings data is lagged, and we may have a clearer picture of more meaningful bank demand once the second quarter 2025 data is available. However, a meaningful uptick in bank demand for CMOs would go against a multiple-year trend of a weakened appetite for the product.
Money manager and hedge fund demand
Quantifying demand from money managers and hedge funds can be somewhat more challenging. Money managers do report holdings at the CUSIP level but that reporting is delayed and tracking hedge fund purchases of MBS requires relying on Treasury data that tracks foreign purchases of US agency debt and MBS by foreign investors. Purchases of MBS by investors in the Caribbean serve as a reasonable proxy for hedge fund buying but leaves some ambiguity as to whether that demand is coming in pass-though or structured form. As of the end of March, the largest mutual funds benched to the US Aggregate Bond Index held very little in the way of CMOs, suggesting that money manager demand may be coming from either smaller or unconstrained bond funds rather than large index buyers (Exhibit 3). Hedge fund buying surged in May with funds adding more than $20 billion in net MBS exposure.
Exhibit 3: Only a few large mutual funds own CMOs
Source: Santander US Capital Markets, Bloomberg LP
Relative value driving hedge fund and money manager purchases
Elevated demand for CMOs from hedge funds and money managers looks to be primarily driven by attractive relative value. CMO floaters offer wide spreads, little interest rate duration and finance efficiently, making them a competitive levered carry vehicle for hedge funds. And strong inverse IO execution on the other side of the structure has left floater spreads relatively wide, creating the opportunity for funds to generate total return if spreads were to tighten on strip floaters with reasonably long spread duration. Depending on the cap, hedge funds can generate estimated levered returns of 13% to 22% (Exhibit 4). To date, the majority of hedge fund buying has been localized to lower caps with more spread duration that should show a more pronounced price response to Fed cuts than higher cap strikes.
Exhibit 4: Floaters offer attractive levered returns for hedge fund investors
Source: Santander US Capital Market
The value proposition for money managers is somewhat different but no less compelling as floaters currently offer a substantial hedge adjusted total return advantage over the underlying collateral. An example of this is a bond like STRU SAN-6328 FA, a 7.0% cap PAC floater backed by $300, 000 maximum loan balance 6.0% pools. Comparing the 7.0% cap floater to one of the underlying pools, FN DD5528, shows that while the fixed-rate pool offers slightly more Treasury OAS, the floater offers markedly better hedge-adjusted total returns, besting the pool by anywhere from 1.35% to 3.64% across modeled scenarios (Exhibit 5).
Exhibit 5: Floaters offer better hedge adjusted returns than underlying collateral
Source: Santander US Capital Markets, YieldBook
Note: 2yr and 5yr duration hedges are expressed as absolute returns. HR adjusted return expresses the hedge return in each scenario times the duration neutral hedge ratio. Net returns are calculated as the asset return less the HR adjusted return. Floater advantage is the hedged floater returns less the hedged fixed rate specified pool return.
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