Opportunities in GNMA Adjustable Rate Mortgage Securities
By David Farris
GNMA adjustable-rate mortgage-backed securities (MBS) currently offer attractive spreads to treasuries for banks that wish to invest on the 3 to 5 year part of the yield curve. These investments typically offer good liquidity and no credit risk. In addition, they have monthly cash flows which can be reinvested in new loans or higher yielding investments in the event rates continue to move higher.
The example security analyzed here is a 5/1 GNMA ARM that has a fixed coupon for 5 years and then resets annually at the 1y TSY +1.50%.
10 CPB in Exhibit 1 assumes that the bond prepays at a 10% constant prepayment rate (CPR) for the first 5 years until the bond reaches the first reset. At the first reset, the remaining balance is assumed to pay off at 100.00, thus ignoring any cash flows after 5 years. Valuing just the fixed part of the ARM (the first 5 years) shows a 4.84% yield to the 3.75 year TSY and a 73 bps spread. At the first reset 5 years out, the investor now owns a bond that resets annually at the 1yr TSY + 1.50% with 1.00% annual caps. Although usually minimal, there is still a small amount of duration associated with the floating portion of GN ARMs after the fixed period due to 1 year between coupon resets and the periodic caps can also introduce some duration when interest rate moves cause the coupon to be capped or floored out.
15 CPB assumes the bond prepays at 15% CPR for the first 5 years and then balloons at 100.00. This faster speed assumption does not materially change the yield or spread but does shorten the bond by about half a year (3.75 vs. 3.31).
10 CPR through 40 CPR assumes that the bond prepays at the stated CPR for the life of the bond. Notice the yields are all higher in these scenarios vs. the CPB scenarios. This is because the coupon is resetting in these scenarios to 5.50% at the first reset and to 6.25% at the second reset (Current Rates in Exhibit 2), whereas the higher coupons are cut off using CPB since the ARM is assumed to prepay at the first reset. The fully indexed coupon is 6.25%, 4.75% + 1.50%. The coupon does not set all the way up at the first reset due to the 1.00% annual cap. Exhibit 2 also shows what happens to the coupon if the 1 year TSY goes higher or lower at each reset in 25 bps increments and also if it goes all the way to 10.00% and 0.00% to fully illustrate the effect of the annual caps and floors. Buying GNMA ARMs at the higher end of rate cycles makes the tighter 1.00% annual caps more attractive as can be seen in the Lowest Rates scenario because the rate can only reset down 1% at each reset.
The 1yr TSY has to drop from its current level of 4.75% to below 3.00% for the coupon to reset down from the current coupon level of 4.50%, a drop in the 1yr TSY of 175 bps. If rates don’t change from today, the coupon will reset up to 6.25% at the 2nd reset.
Due to the uncertainty of where the 1yr TSY will be 5 years from now, it can help to clarify the value in GNMA ARMs by evaluating just the fixed portion of the bond until the first reset separately from the floating portion of the bond. In this case, the fixed portion has a yield of 4.84% for 73 bps of spread to a 3.75 year WAL (Exhibit 1). Having a good return to the first reset and then a bond that resets to market rates annually thereafter, we believe, represents a good short duration investment for banks.
Please contact your Country Club Bank Sales Representative for further information on the securities discussed here and to find the best investments that fit your risk tolerance and interest rate bias.
This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.
•Not FDIC Insured •No Bank Guarantee •May Lose Value