INSIGHTS

On May 24, 2018

Time to limit your extension risk? Consider Bank Qualified Pac1 Offerings

Last week, mortgage rates in the United States reached the highest level since May 2011 as refinancing activity hit multi-year lows. On a historical basis, rates are still low, but with the Federal Reserve in the midst of exiting their re-investment MBS (Mortgage-Backed Security) paydown program, investors are anticipating higher rates in the not so distant future.

For investors seeking yield, safety of principal, and limited extension risk, Agency-Backed Collateralized Mortgage Obligations (CMOs) that pass the Bank Qualified Stress Test, may check all the boxes. In order to pass the Bank Qualified Stress Test, also known as the FFIEC Test, the underlying security must meet certain criteria in regard to weighted average life and price fluctuations in a +300bps/-300bps (basis point) stress scenario. In most cases, the average life will not exceed five to six years in a +300bps stress test. The average life is defined as the length of time the principal is expected to be outstanding. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid. The average life estimate is heavily dependent on the prepayment assumptions of the underlying collateral.

A clean PAC1 (Planned Amortization Class) tranche is typically the structure used in modelling Bank Qualified Investments. PAC tranches are structured to provide stable cash flows while the companion/support tranche absorbs the majority of prepayment and extension risk. Due to this added safety a PAC tranche offers, it will generally have the lowest yields within the structure. Most PAC tranches will return principal and interest on a monthly basis and have gained popularity by creating bond-like structures out of consumer retail mortgages.

In our opinion, it’s time to shorten duration and limit your extension risk in the Agency CMO market. Search for investments that pass the Bank Qualified or FFIEC Test in order to reduce your extension risk in a rising rate environment. In addition, most Bank Qualified offerings return Principal and Interest on a monthly basis allowing investors to dollar cost average back into the market.

Please contact your AAM Advisory Consultant for more information or to view individual offerings. They can also can provide you with timely portfolio reviews and analysis for your clients’ bond holdings. Contact AAM today or email CapitalMarkets@aamlive.com.

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CRN: 2018-0523-6679 R

Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. A Collateralized Mortgage Obligation ("CMO") is a multi-class debt instrument backed by a pool of mortgage pass-through securities or mortgage loans. Investments in CMOs may involve a high degree of risk and are intended for sale only to qualified investors capable of understanding the risks entailed in purchasing such securities.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.