By the Numbers
No summer break for CMO issuance
This material is a Marketing Communication and does not constitute Independent Investment Research.
CMO desks across the Street had limited opportunity for extended vacations as issuance in August approached $33 billion, falling just shy of July’s nearly $36 billion. August’s issuance represents a nearly 70% increase over the prior year, driven, in large part, by what appears to be strong bank demand as nearly half of the month’s volume was localized in Ginnie Mae floaters. Floater demand from depositories looks likely to remain elevated, even as the opportunity cost of owning floaters rises as the Fed cuts. Banks may look to add duration further out a steepening yield curve, rather than in short duration, fixed-rate MBS.
CMOs continue to take out a substantial amount of MBS supply. They accounted for more than one-third of total gross issuance in July and just shy of 30% last month. This is a stark departure from recent history where CMO issuance commonly accounted for less than 10% of monthly or quarterly supply, admittedly against the backdrop of elevated levels of gross issuance in 2020 and 2021 (Exhibit 1).
Exhibit 1: CMOs tale out roughly one third of gross supply in July and August
Source: Santander US Capital Markets, Inside Mortgage Finance
There were some notable changes to structures in August relative to earlier months. Despite the steady decline in volatility, more CMO buyers reached for the additional protections afforded by PAC structures. Anecdotally, demand for PACs has been driven by money managers, who are likely using them as surrogates for indexing purposes instead of 15-year MBS which remain both rich and in short supply. Sequential structures broadly fell out of favor last month, accounting for just 38% of bonds dealt after accounting for as much as 60% of total volumes earlier this year. The decline in sequential issuance suggests that despite market sentiment shifting towards a more hawkish tone and more aggressive Fed cutting cycle, that banks still favored floaters over locking in fixed-rate yields in the front end of the curve (Exhibit 2).
Exhibit 2: Breaking down CMO issuance by structure
Source: Santander US Capital Markets, Inside Mortgage Finance
Floaters dominated the August CMO issuance cycle, accounting for over $20 billion of the nearly $33 billion dealt last month. While the mix of floater issuance was more balanced earlier this year, it has skewed heavily towards Ginnie Mae deals in recent months as $3 of Ginnie Mae floaters were created for every $1 of conventional last month. The surge in demand for Ginnie Mae floaters suggests banks may be more active buyers of MBS than in prior cycles as the Ginnie label carries limited value for asset managers and hedge funds who have also been active floater buyers (Exhibit 3).
Exhibit 3: Tracking floater supply by issuer
Source: Santander US Capital Markets, Inside Mortgage Finance
Expectations of more aggressive Fed cutting were expressed through a substantial migration down in floater cap last month. Floaters with 6.0% caps, which have generally made up 10% of total floater volume in recent months, made up one-third of last month’s floater issuance. To date, lower cap flows have been dominated by fast money buyers who view floaters as an attractive levered carry exposure with potential upside to spread tightening as the Fed cuts rates. Given this, their investments tend to be localized in lower cap strikes with wider spreads and subsequently greater spread duration that will have greater sensitivity to near-term Fed cuts.
Thoughts on bank demand for floaters going forward
Conventional wisdom has dictated that bank floater investment has, at least to some extent, been borne of elevated front end benchmark rates and little to no opportunity or economic cost associated with being invested in the shorter duration exposure. And that as front-end rates begin to fall, banks will begin to buy short-fixed rate bonds again. However, the potentially more likely path forward is that floaters will continue to be an integral part of banks’ investment portfolios and that they will add duration on the longer end of a steepening yield curve. The advantage to a more barbelled strategy is that it gives banks significantly more latitude to manage interest rate risk given higher levels of rate volatility.
Banks can add duration in positively convex instruments such as CMBS or longer duration last-cash flow CMOs and efficiently asset swap them back if they need to shorten the portfolio duration into a backup in rates. Conversely, if they buy open window, fixed rate CMOs, they have limited ability to hedge the extension risk of those assets into a backup. Owning a barbelled portfolio of floaters and long duration MBS gives depositories far more flexibility to manage duration than owning a homogeneous portfolio of shorter duration, more negatively convex MBS. Furthermore, the continued decline in rate volatility and steepening of the yield curve have served to tighten option-adjusted spreads on inverse IO, leaving floater spreads wide and further limiting the opportunity cost of being invested in the asset class. This technical does not appear to be abating anytime soon and banks appear poised to be able to continue to add floaters at attractive spreads.
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