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Short Reset ARMs Offer Good Value at Low Risk

by David Farris

Since October 19th 2023, the 10-year treasury (TSY) rate has decreased from 5.00% to 3.80% (as of 12/28/2023), a decrease of 120 basis points (bps).  The 5-year TSY also currently stands at 3.80% while the 3yr TSY and 2yr TSY are 4.00% and 4.25% respectively with Fed Funds still at 5.50%.  The rally over the last two months in the bond market has made it increasingly difficult to find 5.00% yields.  Thirty-year 5.00% fixed rate agency MBS still offer 5.00% yields at a slight discount.  Those investments are a 6.50-year duration though, so for investors targeting a 5.00% yield, or close to it, with a lower duration target, we believe ARMs with shorter months to reset offer a great alternative.

The pool shown below has 3 months to roll from a January 2024 settlement.  The bond floats at the 1yr TSY +1.50% so a fully indexed coupon would be 6.33% (4.83% 1yr TSY + 1.50% Margin).  This bond currently has a 3.50% coupon but has 1.00% annual periodic caps, so the bond coupon will only reset up to 4.50% at the next reset in 3 months.  It will then have a 4.50% coupon for the next 12 months.  For this reason, the yield is calculated below (Exhibit 1) to the SECOND reset 15 months out at which time the bond is assumed to pay off at 100.00.  This yield is 4.83% in the first scenario 100 V9 (assumes 30% CPR for the 15 months) and accretes the discount to the second reset 15 months out.  

Exhibit 1

For a bond with a duration of 2.64 years and an average life of 3.16 years (Exhibit 2), 4.83% is an attractive return (vs. bullets and discounted callable agency in the low 4% range) and is a spread to the comparable TSY of 75 bps (4.83%-4.08%).  Once the bond is through the second reset 15 months out, the bond holder owns a floater at 100.00 that resets annually.  For the coupon to reset lower than 4.50% at the second reset in 15 months, the 1yr TSY would need to drop below 3.00%.  With the current 1yr TSY at 4.83%, this is a drop of 183 bps.  For a decrease any less than that, the bond will either stay at 4.50% or will actually reset higher at that time.  In addition, the 1.00% annual periodic cap/floor for GNMA ARMs restrict movements down in coupon to 100 bps annually should the 1yr decrease a lot further.

One other item to note on Exhibit 2 is that the C+0 scenario, the middle (base) scenario showing the 5.66% yield, assumes the index remains constant so the coupon will eventually set up to 6.33% (4.83% 1yr TSY + 1.50% Margin) which is not likely because the bond will just prepay instead.  This is why it is important to analyze the bond to the first reset, or second reset in this case, with the understanding that a floater at 100.00 is owned thereafter.

Exhibit 2

Exhibit 3 shows the computed price profile for this bond.  The percent change in price for a -100 bp interest rate shift is 1.0% and the price change +100 is -1.9%, further indicating the low risk profile for this bond.

Exhibit 3