How Big Money Bets for and against Rates: Part 2, Interest-Only Bonds
One of the primary objectives of the Fed’s policy was to enable as many homeowners as possible to refinance into a lower mortgage rate. The Fed affected rates not only through its language and guidance but also through the outright purchase of agency mortgage-backed securities (MBS). Through the years, while the Fed has bought securities (as well as implemented such programs as the Home Affordable Refinance Program for the credit-impaired borrower to refinance), more and more homeowners have refinanced into a lower-cost mortgage.
As a result, the landscape of the MBS market has dramatically changed. Fewer bonds are available for investors to hold, with the Fed purchasing nearly two-thirds of all new issuances, and the new bonds outstanding in the market have lower coupons and greater extension risk. The investors still holding premium mortgages are facing headwinds from faster prepayments, which causes their bonds to be returned at par. The majority of 30-year agency MBS bonds outstanding trade at a premium of 5+ points (30-year threes at roughly 103, fives at roughly 108, and sixes at roughly 109); thus, prepayments returned at par have been a big hit to some bonds and have left investors with less income than they expected.
Given the “pain” that investors have endured through faster prepayments leading to lower yields, many have sought the refuge of lower premium bonds. Given the premiums where many mortgage coupon bonds are trading, most par-dollar-price bonds must be created synthetically. The way Wall Street can provide MBS bonds that trade closer to par is by “stripping” the coupons. Investment banks’ structuring desks can satisfy the demand for mortgages with a price closer to par by, for example, taking a pool of mortgages with a coupon of 4% and creating a bond with a 1.5% coupon. They can then take the remaining 2.5% of coupon and create an interest-only (IO) security.
Investors looking to protect against rising rates have found buying IO bonds to be a viable option. In the fixed-income world, IO bonds are some of the few bonds that are truly “negative duration.” This means that they should appreciate in value as rates rise. Because the holders of IO bonds receive just the interest portion of the mortgage, the bondholders would like prepayments to be as slow as possible so a greater amount of interest flows to them. As interest rates rise, prepayments should slow, and the investor should receive a greater amount of cash flows from the IO bond and thus higher yield. Agency mortgage derivatives, such as IO bonds, traditionally trade at higher option-adjusted spreads (OAS) because there are not natural buyers of the bonds, meaning there are not institutions with a natural asset-liability need for such a cash flow. Right now, it isn’t uncommon to see IO bonds trade at an OAS of 1,000 bps or more. As a refresher, the OAS is the additional spread after adjusting for the option value. This is the compensation that buyers, such as hedge funds, get for taking on the volatility of this IO bond.
In order for these IO bonds to be created, there has to be a buyer of the stripped down 1.5% collateralized mortgage obligation (CMO). Given the described state of the mortgage market, such institutions as banks, which have been burned on prepayments, have stepped in and created a huge demand for these “stripped-down” bonds. The stripped-down coupon bonds appease the banks (many of which have rules on maximum dollar prices for a purchase) with a stable yield profile as the bond trades at or close to par. With the OAS on the IO bonds trading around 1,000 bps or higher, the OAS on the stripped-down CMO is thus often negative. In short, I believe that the IO buyers are lucky to find a “sucker” to purchase the stripped-down CMO. What the buyers of the stripped-down coupon may or may not realize is that the convexity profile they now own is dramatically different from that of a fuller coupon bond. Should rates rise, the bond will have a much greater duration (price sensitivity) than other bonds. Thus, the investor has traded an arguably more favorable profile of yield/duration outcomes in other rate scenarios in order to have a more stable yield profile today. If rates remain low, the buyers of the bond will see their cash flows called away, while in a rising rate scenario, the bond’s duration rises rapidly because of the low coupon.
In contrast, the initial yield profile for the IO buyer can at times look pretty unappealing. Depending on the type of underlying collateral, a number of IO bonds can trade at negative yields based on current prepayment rates. It’s fair for someone to ask why an investor would purchase a bond with a negative current yield. The answer is that while it may incur negative income in the initial months, the investor is likely projecting slower prepayments in subsequent years, which can make the bond look very appealing — or just the opposite as the stripped-down buyer. As previously described, these bonds are typically purchased with huge OAS of more than 1,000 bps, thus substantially better relative valuation than the other bond.
Although one may be quick to conclude that the “smart money” is the IO buyer and the “dumb money” is the stripped-down buyer, the verdict will be decided based on the path of interest rates/prepayments going forward. In my opinion, the buyers of the IO are buying into a much better risk/reward as reflected by the initial OAS values. As various institutions continue to search for ways to hedge and speculate against rising interest rates, agency MBS derivatives should remain a popular option as long as structuring desks can pawn off the remaining bond on more unsophisticated buyers.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.