Convexity in legacy re-securitizations
admin | July 19, 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 plunge in interest rates this year has made jumbo 2.0 pass-throughs increasingly negatively convex. One potential solution is to shift into more positively convex ‘AAA’ classes of re-securitized legacy loans to create a better and more stable return profile. Even within this sector, not all securities are created equal.
Legacy re-securitizations are comprised of highly seasoned always-performing as well as self- cure and modified re-performing loans. The combination of burnout and credit impairment on some of these loans help drive a generally stable prepayment profile and flat S-curve even when these loans are deeply in the money.
Re-performing loans with forbearance tend to pay even slower than seasoned loans that are simply burned out or credit-impaired. An analysis of fixed-rate loans re-securitized under New Residential’s NRZT shelf shows prepayments on loans with no forbearance peak at 17 CRR when they have 125 bp or more of refinancing incentive. While loans securitized with forbearance on the shelf peak at just 5 CRR. By comparison, non-conforming jumbo loans securitized under the JPMMT shelf with 125 bp or more of refinancing incentive prepay at more than 30 CRR. (Exhibit 1)
Exhibit 1: Comparing S-curves across seasoned legacy and 2.0 loans
Note: Refinancing incentive on loans with forbearance is calculated as the difference between the effective WAC net of forborne principal on the loan over the PMMS rate. Source: Amherst Insight Labs, Amherst Pierpont Securities
To perform a roughly duration neutral analysis, we compare NRZT 2019-1A A1 to JPMMT 2018-2 A3. Both deals are shifting interest structures and the A1 and A3 classes are pass-throughs. The JPMMT deal is 100% agency conforming and jumbo conforming collateral, with flatter S-curves than non-conforming loans securitized on the shelf, and should offer better convexity relative to deals that contain both conforming and non-conforming loans. Both bonds are just north of 3-year durations with comparable yields, even though the JPMMT bond is significantly longer on the curve. The NRZT bond is significantly more positively convex, with a lower option cost and better OAS. These advantages would by and large be further magnified comparing the NRZT bond to higher coupon, newer vintage deals with large populations of non-conforming loans. (Exhibit 2)
Exhibit 2: Comparing risk and return across seasoned legacy and 2.0 loans
Note: All market levels as of COB 7/17/19. Source: YieldBook, Amherst Pierpont Securities
The NRZT ‘AAA’ compares favorably to the JPMMT bond. On a dollar DV01 neutral basis, the better convexity provided by the NRZT collateral drives significant outperformance into 75 bp or greater rally or selloff and only underperforms modestly in the base case and a 25 bp rally. Given the slightly longer duration of the JPMMT bond, cash is used to get the NRZT position dollar duration neutral. Investors could pair the NRZT bond with a floating-rate asset with spread to enhance returns instead of using cash, providing an even more favorable profile versus the prime pass-through. (Exhibit 3)
Exhibit 3: Comparing total return across seasoned legacy and 2.0 pass-throughs
Note: Total returns assume parallel linear shifts in the yield curve to the horizon, reinvestment at 1-month LIBOR and repricing at constant OAS. All market levels as of COB 7/17/19. Source: YieldBook, Amherst Pierpont Securities
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