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Total return through deleveraging in non-QM, RPL MBS
admin | February 15, 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.
It’s no secret that mortgage loans in non-QM trusts have prepaid quickly, in some cases very quickly. What may be less obvious is that these elevated prepayments have driven significant deleveraging in many of these trusts. This deleveraging has started to spur a flurry of rating agency upgrades on seasoned non-QM trusts. These upgrades have driven bond spreads tighter, lifting potential total returns in sequential-pay mezzanine classes that combine spread duration and a relatively steep credit curve.
Private label RMBS has attracted capital for a host of reasons. Diversification, spread and potential risk-adjusted returns continue to draw inflows. But newer rated non-agency MBS have added a structural twist. Deleveraging and subsequent spread tightening have been one of the primary drivers of capital into re-performing loan securitizations that direct principal first to the ‘AAA’ class, then the ‘AA’ class and so on down the capital structure. This sequential-pay approach is a departure from the legacy market that often employed a shifting interest principal allocation between seniors and subordinate classes. Non-QM securitizations employ a hybrid structure with short pro-rata pay ‘AAA’ through ‘A’ classes and sequential-pay subordinates below them.
The results of deleveraging in non-QM structures have started to show up in rating agency actions. On February 1, Kroll took action on five classes of VERUS 2017-1, a non-QM trust issued in February of 2017, upgrading five classes of the trust anywhere from two to four notches. The largest upgrades came further up in the capital structure where all original investment-grade bonds jumped up a full ratings category and non-investment grade tranches upgraded two notches. Kroll noted that the deal had paid down to less than a 50% deal factor with no losses and low delinquency rates. This type of collateral performance potentially creates a better opportunity for upgrades on mezzanine classes of non-QM bonds compared to potential upgrades in RPL deals as prepayment rates will likely remain elevated in non-QM trusts while speeds have slowed meaningfully in more recent RPL deals.
Non-QM and RPL transactions with approximately the same deal age help highlight differences in deleveraging. VERUS 2017-1 and TPMT 2017-1, for instance, were both issued in the first quarter of 2017. Looking across the capital structure of the two deals, the VERUS trust has seen credit enhancement more than double across the majority of the capital structure while the Towd Point trust has seen roughly a one-third increase in credit enhancement (Exhibit 1).
Exhibit 1: Certain non-QM trusts de-lever faster than RPLs
Source: Bloomberg, Amherst Pierpont Securities
While elevated prepayments may skew total returns in favor of non-QM mezzanine bonds over RPLs, there are some mitigating factors. First, while both non-QM and RPL mezzanine bonds pay sequentially, non-QM trusts are generally collapsible with a 30% deal factor, potentially curtailing the average life and spread duration of the non-QM bonds. Additionally, while the credit curve is often steeper in non-QM mezzanine bonds than in RPL structures, the bonds have significantly less spread duration and as a result, an upgrade and subsequent spread tightening will not trigger the same amount of price appreciation as an equivalent upgrade in an RPL transaction. Furthermore, prepayment speeds have been elevated in non-QM transactions relative to RPLs, but the fast pace in non-QM may cool and the gap narrow.
Apart from relative value between non-QM and RPL MBS, the potential for return from deleveraging in non-QM is becoming clearer. Deleveraging has helped returns in RPL securitizations for years, and non-QM seems set to see similar benefits as well.
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