Relative value in IO backed by seasoned legacy loans
admin | June 28, 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.
The steady drop in interest rates this year has started to spur prepayments of 50 CPR or higher in new prime and near-prime private MBS, sending some investors looking for more stable cash flows. There may be a surprising source: interest-only or IO bonds backed by seasoned legacy collateral. These IOs offer negative duration without significant negative convexity, and the likely carry is attractive. The IOs could work well for portfolios that hedge IO or use it to shorten duration in a broader portfolio.
Stable prepayments in legacy collateral
The appeal of IO backed by legacy collateral clearly is the collateral itself. Loans backing NRZT trusts, for example, come from exercising call options on legacy private label deals. The collateral is a combination of seasoned always-performing, self-cured and modified re-performing legacy loans. The combination of burnout and credit impairment help drive generally low and consistent prepayments despite high WACs with significant refinancing incentive. Lower mortgage rates have by and large not driven a material uptick in speeds across the program. (Exhibit 1)
Exhibit 1: NRZT 2016-1 3-month VPR versus Freddie Mac Primary Rate
Although NRZ and other legacy loans may be newly re-securitized, tracing the loans back to their former lives in legacy trusts shows both pre- and post-issuance performance through a number of refinancing waves. NRZT 2018-1A, for example, has only 14 months of prepay history. The WALA on the collateral, however, is 140 months. The longer pre-securitization prepayment rate is calculated using weighted average historical prepayment rates on the always performing and re-performing loans in the called legacy deals collateralizing the NRZT trust (Exhibit 2).
Exhibit 2: NRZT 2018-1 – Pre and Post Securitization Prepayment Rates
Nuances of IO structure
The combined effect of structure and collateral creates an instrument with both negative duration and limited negative convexity—or positive convexity based on some models— that could pair well with longer duration, negatively convex classes of newly issued private label RMBS. IO stripped off the ‘AAA’ classes of NRZT seasoned loan trusts are pass-through strips off a shifting interest structure, making them similar to front sequential IO. The subordinate classes are locked out from receiving unscheduled principal for five years if the deal passes performance triggers, paying the principal instead to the ‘AAA.’. In the case of NRZT 2018-1A, the ‘AAA’ class currently represents the top 71.4% of the structure. The A1IA is a WAC coupon IO currently struck at 1.87%. The coupon on the IO can drift higher or lower based on the coupon of loans that leave the pool either through prepayment or default and subsequent liquidation. And while the prepayment rates have proven to be stable, they are likely not completely impervious to a higher rates and a subsequent slowdown in speeds causing it extend and giving it negative duration. (Exhibit 3)
Exhibit 3: Collateral and Risk Profiles of NRZT and Seasoned FNMA IO
Positively convex IO is extraordinarily rare. Given their levered prepayment risk, IOs generally exhibit significant amounts of negative convexity. Models view some IO off legacy collateral as positively convex, although these IO have not been tested across a wide set of markets. The opinion of traders on realized convexity varies from essentially zero to a small negative.
Relative value to agency IO
The NRZT ‘AAA’ IO compares favorably to a comparable agency IO. Comparing the NRZT IO to a seasoned higher coupon agency IO like FNR 2015-33 AI, a 5% IO backed by 5.49% WAC, 190 WALA Fannie Mae 5.0% collateral is a reasonable albeit imperfect comparison. The Fannie bond has a much lower WAC and is more seasoned than the NRZT bond. The bonds trade to roughly comparable IO multiples with the Fannie IO trading at roughly a 3.7 times coupon multiple. The Fannie Mae IO has significantly more negative duration given the fact it is a true pass-through strip and the cash flow can extend more into a back-up in rates. Pairing the Fannie Mae IO with TBA FNCL 3.0% leaves it duration-neutral to the NRZT IO. The NRZT IO still outperforms the combination of agency IO and TBA by a projected 44 bp in the base case. As rates shift, the NRZT IO significantly outperforms the combo by as much as 249 bp given the far more stable collateral. (Exhibit 4)
Exhibit 4: 12 Month Total Return – NRZT versus seasoned FNMA IO & TBA
Given its negative duration, relative stability and attractive yield in a low rate environment, seasoned private MBS IO offers a clear relative value alterative to higher coupon seasoned IO.