DUS bonds: An effective strategy for a steepening yield curve

Here, we review how Fannie Mae (FNMA) DUS bonds can benefit your bond portfolio. It's been a long year for anyone waiting for rate cuts. Tariff uncertainty and lingering above-target inflation have put the Fed in wait-and-see mode. However, the waiting game might be over soon. Cooling economic activity and large, downward revisions to labor market data have put rate cuts back on the table for this fall. Most market participants expect 50 basis points of easing through the end of 2025.

The short end of the yield curve has adjusted, with the 2-year treasury currently yielding 3.50%, and the 5-year treasury yield just under 3.6%. As a result, the easy 4.0% treasury and agency bullets are firmly in the rearview. However, a bullet-like structure is still a possibility. In response to these market shifts, we would like to highlight a bullet-alternative structure that accomplishes essentially the same thing but with an additional spread: the Federal National Mortgage Association, commonly known as Fannie Mae (FNMA), delegated underwriting and servicing (DUS) bond, which is the simplest within the agency commercial mortgage-backed security (ACMBS) category.

DUS bonds are structured with a yield maintenance provision and a balloon maturity for a very bullet-like structure. Yield maintenance is a prepayment penalty‡ designed to safeguard investors against losing interest income when a borrower decides to repay a loan ahead of schedule. These securities are FNMA-wrapped at $100, so they work well when purchased at a discount.

The typical DUS bond security is often backed by a single multifamily property loan or a very small pool of loans. The most common structure for bank portfolios is a 5-year balloon (with a 4.5-year yield maintenance period). However, longer structures are also available. The hard final maturity date, combined with strong prepayment protections, is an attractive option for bank portfolios that need stable, predictable cash flows for liability-matching purposes.

In 2024 and 2025, the DUS bond market remains strong, with Fannie Mae issuing around $55 billion in new multifamily, DUS mortgage-backed securities (MBS). Fannie Mae continues to guarantee about 21% of the $2.3 trillion multifamily mortgage debt outstanding, highlighting its market centrality in agency multifamily finance.

Also, unlike single-family MBS, which may experience negative convexity if rates fall and homeowners refinance, DUS bonds yield maintenance and penalty features that reduce early pay-off risk, or at least compensate the investor for the loss of interest income.

Let's look at an example. The Bloomberg table below shows a slightly seasoned 7-year/6.5-year DUS structure. It pays a 3.975% coupon and is offered at a discount price of $99-21. This results in a 4.08% yield-to-maturity for an average life of 5.95 years. The DUS bond offers a +40 basis point pick-up in spread when compared to Treasuries of a similar term. Also, since the bond is offered at a discount, any early payoff would result in accelerated accretion income.

Source: Bloomberg

Depending on prevailing movements in rate markets and the specific coupon attached to a security, DUS bonds are also often offered at premiums to par. As with any callable bond purchased at a premium, understanding the risk and probability of an early prepay is crucial, even with a yield maintenance provision intact. While the yield maintenance provision acts as a strong refinance deterrent for the borrower, the economics of a payoff may be driven by other factors, such as a change of property ownership.

It is important to understand how the FNMA yield maintenance provision works in various rate environments. Yield maintenance is designed to discourage borrowers from voluntarily prepaying the mortgage and to compensate the investor in the event of voluntary replacement.

Simply put, the yield maintenance penalty is the present value of the difference between the cost to the borrower (wholesale acquisition cost or WAC) and the prevailing yield on treasury notes of the same maturity. As a result, penalties increase as rates fall and decline as rates increase - like the price of a bond.

Since a premium DUS bond carries an obviously increased risk to performance on early prepays, spreads on higher-coupon DUS bonds offered at a premium can be considerably higher than comparable DUS bonds offered at a discount. When evaluating premium DUS bonds, investors want to make sure they are getting compensated for the additional premium risk and have a good feel for the yield maintenance outcomes in various rate scenarios.

As is true with all bond portfolio asset classes, having a diversified book of DUS bonds goes a long way to help mitigate some of those prepay risks that always exist in some form, no matter what price level you bought a given bond. With a range of structures, maturities, coupons, and entry points, you can smooth the unknown effects of a single bond that may unexpectedly prepay against a bundle of similar loans that hold on the books as expected.

Layering a diverse set of bonds into your portfolio can be very defensive to the overall performance of your agency MBS holdings.

Community Investment Act (CRA) credit when utilizing DUS bonds

We also find many banks utilize DUS bonds as an efficient means to obtain CRA credit in locations where it is needed. Some DUS bonds are specifically flagged as CRA eligible based on the percentage of low-income tenants residing at the property.

Other DUS bonds that may not be specifically flagged as CRA eligible but fall in low-to-moderate income (LMI) districts where credit is needed can be considered for CRA credit. The investing bank needs to have a conversation with its examiners, who ultimately have the discretion to allow an LMI DUS bond count for CRA credit even if the property is not specifically tagged as low-income.

Learn how UMB Bank Capital Markets Division's fixed income sales and trading solutions can support your bank or organization, or contact us to be connected with a team member.

When you click links marked with the "‡" symbol, you will leave UMB's website and go to websites that are not controlled by or affiliated with UMB. We have provided these links for your convenience. However, we do not endorse or guarantee any products or services you may view on other sites. Other websites may not follow the same privacy policies and security procedures that UMB does, so please review their policies and procedures carefully.

Disclosure

This communication is provided for informational purposes only. UMB Bank, n.a. and UMB Financial Corporation are not liable for any errors, omissions, or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information is believed to be reliable, but we do not warrant its completeness or accuracy. Past performance is no indication of future results. The numbers cited are for illustrative purposes only. UMB Financial Corporation, its affiliates, and its employees are not in the business of providing tax or legal advice. Any materials or tax‐related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. The opinions expressed herein are those of the author and do not necessarily represent the opinions of UMB Bank or UMB Financial Corporation.

Products, Services and Securities offered through UMB Bank, n.a. Capital Markets Division are: NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED

About the authors:

Francis Scheuerman is senior vice president and investment officer at UMB Bank, n.a. Capital Markets Division. He offers transaction and portfolios services for banks, institutions, and financial advisors throughout the Midwest.

James Carlile is vice president and an investment officer at UMB Bank, n.a. Capital Markets Division. He is responsible for helping institutional clients understand how to best manage their bond portfolios and interest rate risk.

Javier Garcia is an investment officer at UMB Bank, n.a. Capital Markets Division. He is responsible for working with banks and institutional clients regarding interest rate risk management and fixed income portfolio strategies.