Written by Darren Stumberger, as originally published in The Reverse Review.

 

Although arguably less this month than last, the market continues to deal with a significant amount of interest rate volatility. Since November, rates have backed up substantially and are poised to reset even higher to the extent economic growth and inflation pick up.

In the current rate environment, both floating-rate securities and interest-only securities make a lot of sense for institutional fixed-income investors. Floaters allow investors to stay defensive but have some protection against rising rates. For those willing to take increased prepayment risk (albeit muted and predictable), IOs make sense in the event that rates back up even further. The robust monthly issuance of HREMICs provides a decent opportunity, offering both floaters and IOs off of HMBS ARM collateral.

These securities are especially practical now for a number of reasons:

  • HMBS and HREMICs are Ginnie Mae securities so they carry the full faith and credit of the U.S. government and trade at a 0 percent risk weighting for banks. Banks do not have to hold additional capital against these assets. This provides better risk capital-adjusted returns than competing alternatives.
  • Furthermore, as capital requirements are becoming more onerous for securitized products and banks across the board, Ginnie Mae securities fare well under Basel III guidelines, increasing their attractiveness and sponsorship. 
  • Ginnie Mae has generally been left out of the policy and headline risk that housing finance and the restructuring of Fannie and Freddie are currently under.
  • As these products lack rate sensitivity and age more, HMBS have overall good convexity.
  • There have been recent increases in the number of deals in the market and dealers sponsoring the sector, so supply is available. We expect supply to stay elevated and continue to be dominated by HECM ARM collateral.
  • Lastly, one may see good relative value in HMBS. In the current spread environment, where many asset classes are trading at historically tight levels, focusing on this niche government-guaranteed sector is one of the best ways to pick up yield. Recall that HMBS cash flows can be erratic as there are no scheduled payments, however the investor is often compensated with a much larger spread. As a result, HMBS can look attractive to yield and total return-oriented investors, but less appealing to current income seeking investors.