Relative value in 2.0 investor collateral
admin | September 13, 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.
Whether it’s prime or non-QM, investor loans have prepaid slower than owner occupied loans in recent months. Investor pools, which trade at a premium to TBA in agency space, not only trade back of TBA but quite often even trade wider than far more negatively convex jumbo pass throughs in in prime space. Investor deals have historically priced wider than other forms of non-QM collateral as well despite offering better convexity. As a result, investor loans across the spectrum of PLS appear to offer attractive relative value.
A flatter S-curve
Investor loans in PLS have historically exhibited less response to a similar amount of refinancing incentive as owner occupied or loans backed by non-primary residences. Investor collateral in prime space are by and large agency eligible loans that found a home in private label trusts as a result of better execution in PLS relative to the cost of a base guarantee fee plus associated loan level pricing adjustments (LLPAs) charged by the Enterprises. Given this, we would expect the loans to exhibit similar behavior to agency investor loans. On a SATO adjusted basis, prime investor loans prepaid 10 CRR slower than owner occupied loans given 50 bp of refi incentive and 15 CRR slower than owner occupied ones given 100 bp of incentive. Obviously, other factors may be driving the level of prepayments when only accounting for occupancy status and adjusting for SATO, the most prominent one being loan size. However, given the fact that high balance loans will make up some, if not all of the collateral in traditional prime trusts PLS investors should be able to capture the convexity advantage afforded by investor collateral.
Investor loans in non-QM trusts exhibit a similar muted response to refinancing incentive. The challenge in non-QM space is that after adjusting for SATO, there are a very limited amount of investor loans with more than 50 bp of refinancing incentive. Non-QM investor loans with 25 bp of refi incentive have paid 15 CRR slower than owner occupied ones. Another wrinkle in non-QM space is there are two flavors of investor loans, those underwritten using the borrowers assets, income and credit history and those underwritten using a CMBS style debt service coverage style underwriting, where rental income on the property is used in lieu of the borrower’s income. DSCR loans in non-QM trusts have to date prepaid even slower than traditionally underwritten ones.(Exhibits 1& 2)
Exhibits 1 & 2: S-curves across prime and non-QM
Differentiation across shelves
Investor only prime deals have consistently paid slower than their prime jumbo counterparts in recent months with even the fastest paying, high WAC investor deals prepaying half as fast as peak prime jumbo speeds. With that said, there has been some variance in speeds across investor only deals. In terms of absolute speeds, investor deals with 5.25% or greater saw one-month speeds north of 25 CPR in August. Comparing s-curves over a two-year horizon across the four major investor issuers shows that while all issuers have reasonably steep s-curves shows relatively similar responsiveness to refinancing incentive especially when loans are deep in-the-money. Investor loans securitized in the JPMMT shelf exhibit faster out-of-the-money speeds than other shelves which looks to offer better convexity with the caveat of limited protection deep in-the-money relative to other shelves. Given the current rate environment coupled with similar responsiveness to incentive, investors should gravitate towards lower WAC investor deals which should offer the best source of prepay protection. (Exhibit 3)
Exhibit 3: S-curves across major prime investor shelves
Conversely investor loans in non-QM space tend to have much flatter S-curves than their prime counterparts. While operating with the same constraints of having a limited amount of deep in-the-money observations after adjusting for SATO it appears investor loans in most non-QM offer attractive call protection up to 50 bp in-the-money. Investor loans securitized in the AOMT, DRMT, HOF and VERUS shelves have exhibited elevated out of the money speeds, potentially offering attractive convexity, minimizing extension risk if rates sell off, collateral prices drop and par date and clean-up calls fall out-of-the-money.
Exhibit 4: Investor loan S-curves across major non-QM shelves
Thoughts on relative value
New issue prime 3.5% coupon super senior pass throughs are currently trading at a spread of 160-165 bp over interpolated swaps. Assuming a pricing speed of 15 CPR, that implies the pass through trades at a spread of approximately $1-08 back of UMBS TBA 3.5% pass throughs. By comparison, WFMBS 2019-3, a newly issued prime jumbo deal priced it’s 3.5% pass through class at $1-02 of TBA 3.5%. Given the slower speeds that investor collateral has offered to date, we would think that the market should price investor pass throughs inside of rather than wide to pass throughs backed by jumbo collateral. We would expect the spreads on investor pass throughs to tighten from here, especially if the magnified differences in prepayment rates hold up. Historically, non-QM trusts backed fully by large concentrations of investor loans have traded wider than comparable deals backed by other forms of non-QM collateral. While arguably deeper credit bonds should trade at some concession, especially those with large concentrations of DSCR loans given the lack of performance history of these loans under a stressed home price environment, bonds further up in the pro-rata investment grade capital structure should arguably trade tighter than pro-rata seniors backed by other forms of non-QM loans.