Scanning for value in the new RMBS
admin | January 25, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
On an option-adjusted basis, newly issued prime subordinate classes offer the best relative value in new RMBS across different types of collateral and different capital structures. At the top of the capital structure, investor-only and non-QM ‘AAA’ classes offer significantly better OAS than prime or expanded prime super-senior pass throughs.
As the new issue market continues to grow, investors have more options to extract relative value across capital structures, credit and convexity profiles. For the better part of a decade, issuance has been moribund and dominated by prime jumbo. But that is all starting to change. Expanded credit, GSE eligible and investor loans are all being securitized in growing amounts, expanding the landscape for relative value.
Looking across prime, expanded prime, different flavors of non-QM, GSE eligible and investor only deals shows there are a couple high level themes. First loans being securitized today look solid from a credit perspective. Expected losses on prime deals look to be little more than a handful of basis points while expected losses on expanded credit deals look to be in the neighborhood of four to five points. From a prepayment perspective, speeds on non-QM should slow to some extent but will likely remain elevated. Fast speeds coupled with potential callability should favor seasoned discount non-QM bonds across the capital structure. Investor-only deals look to have the best convexity of all flavors of collateral while bonds backed by prime, expanded prime and GSE-eligible loans look to have the worst.
Expected pristine credit performance coupled with significant structural leverage make investment grade and non-investment grade prime mezzanine and subordinate classes some of the most attractive investments along with investor only mezzanine bonds on an option adjusted basis. Investor only non- investment grade mezzanine bonds like VERUS 2018-INV1 offer some of the widest nominal spreads in the new issue market with some of the lowest option cost. (Exhibit 1)
Exhibit 1: An option adjusted view of relative value
While non-investment grade bonds appear to offer the best relative value on an option-adjusted basis, not all investors can play in speculative credits. Given this we break down our analysis by rating category to ascertain what bonds offer the best value within a given ratings category. At the top of the capital structure shorter investor-only and non-QM ‘AAA’ bonds show well despite trading to nominally tighter spreads than prime pass-thoughs. Expanded prime pass-throughs trade to some of the tightest nominal and option-adjusted spreads across the ‘AAA’ bonds analyzed. Across prime and expanded prime pass-throughs, higher coupons that trade at wider nominal spreads back of TBA offer better OAS than tighter, lower coupons.
Exhibit 2: OAS and risk across the AAA stack
Moving further down the stack in investment grade mezzanine bonds, prime jumbo and GSE-eligible mezzanine bonds generally offer the widest spreads of any collateral profile, with OAS generally widening further down the stack as nominal spreads widen, option costs remain relatively constant and the probability of the bonds attaching remains low despite the fact that tranches are thin and have little credit enhancement relative to other mezzanine bonds analyzed.
Given the structural differences between prime and non-QM deals, non-QM ‘AA’ and ‘A’ mezzanine bonds trade to tighter nominal spreads than their prime counterparts. Non-QM ‘AAA’ through ‘A’ bonds pay pro-rata, making them shorter than prime mezzanine bonds, which divert more cash flow to the senior bonds initially. As a result, non-QM ‘AA’ and ‘A’ bonds generally have much shorter average lives and duration than their prime counterparts and trade to tighter spreads as a result. Expanded prime middle mezzanine bonds are generally shorter and trade to tighter nominal spreads as well. However expanded prime collateral tends to have a higher option cost than non-QM and generally trade to tighter a tighter OAS given comparable nominal spreads to non-QM bonds. (Exhibit 3)
Exhibit 3: OAS and risk across the AA and single A stack
Looking across ‘BBB’ investments, investor- only ‘BBBs’ offer some of the widest nominal spreads and lowest option cost of all collateral profiles. In expanded primed deals, the B3 ‘BBB+’ classes appear to offer the best relative value within that capital structure. Locked out ‘BBB’ classes of non-QM deals have some of the tightest OAS, but investors may find value both ‘BBB’ and non-investment grade mezzanine and subordinate bonds in these structures for other reasons. Since non-QM deals employ a hybrid pro-rata senior, sequential subordinate structure, non-QM mezzanine and subordinate bonds can be a good source of total return. Elevated prepayments will cause the senior pro-rata part of the capital structure to de-lever quickly, driving potential rating upgrades and subsequent spread tightening. The potential offset to that would be call risk as many ‘BBB’-rated non-QM bonds trade at a premium to par. (Exhibit 4)
Exhibit 4: OAS and risk across the BBB stack
Certain non-investment grade credits offer the widest OAS available in the new issue market. However speculative credits also have the widest range of option-adjusted spreads of any part of the capital structure. Using OAS as a relative value metric at the bottom of the capital structure can often be a tricky exercise. Given how thin and structurally levered deep subordinates can be, small changes in model projected losses can often yield large changes in a bond’s OAS. Additionally, any model will diffuse hundreds of interest rate and home price paths and some of those paths are likely extremely remote but may have an outsized impact on a bond’s OAS. If investors choose to discount extreme scenarios, OAS may not be the optimal metric to ascertain relative value. With that caveat, ‘BB’ and ‘B’ rated investor-only, prime jumbo and GSE eligible bonds offer some of the widest OAS. While non-rated first loss bonds generally trade to the tightest OAS. (Exhibit 5)
Exhibit 5: OAS and risk across the non-investment grade stack