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October 28, 2016  

Risk-Transfer Notes Showing Cracks

A long-running rally in the market for risk-transfer bonds issued by Fannie Mae and Freddie Mac appears to be over.

In the past few weeks, the most heavily traded versions of the bonds — those with below-investment-grade ratings down to single-B-minus — have dipped in value. Case in point: So-called M3 notes that Fannie sold via its Connecticut Avenue Securities shelf, with single-B ratings and average lives of eight years, are trading at 410 bp over one-month Libor. That’s out 10 bp since mid-October. Comparable paper from Freddie’s Structured Agency Credit Risk program is at 415 bp, 15 bp wider than mid-October and 35 bp wider than late September.

Traders and researchers are at something of a loss to explain the widening, which reverses a trend that began in February. Dollar prices had been rising at the same time, reaching well above par amid signs of strong demand. Now, the thought among some industry participants is that hedge funds may be cashing out of their positions ahead of an expected interest-rate hike in December by the Federal Reserve.

“With non-agency RMBS spreads hovering around one-year tights, and the risk events looming on the horizon, this may be investors taking profits and taking a breather until the election pans out and the Fed provides more clarity,” Wells Fargo senior analyst Vipul Jain wrote in an Oct. 24 report.

Agency mortgages remain fundamentally strong in terms of credit risk, Jain noted. But with risk-transfer bonds still trading above par, there’s likely more downside risk than upside potential. He’s advising the bank’s clients to proceed with caution, and to focus on higher-rated notes.

Risk-transfer bonds are unsecured and unguaranteed securities that help the issuing agencies shed the risk associated with pools of reference mortgages. Each transaction typically encompasses a large senior class that is retained by the issuer, along with up to three mezzanine pieces and an unrated first-loss component, which also is retained.

So far this year, Fannie and Freddie have issued a combined $11.5 billion of risk transfer paper, excluding unrated classes.