Mining for relative value in CRT subordinates
admin | February 28, 2020
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 sustained rally in the credit risk transfer market has come to a halt as spreads on deep subordinate classes have widened lately as much as 60 bp. Prices on CRT B2 classes have dropped by as much as five points. Bonds further up the capital structure fared better with spreads wider by roughly 15 bp. While elevated prepayment risk looks to weigh on open-window or shorter mezzanine classes trading at premium prices, wider spreads on locked out bonds at the bottom of the capital structure may provide investors with a more attractive entry point to add residential credit exposure.
Given strong fundamentals underpinning the asset class, CRT subordinate classes have rallied substantially over the past year with on the run B1 classes tightening by roughly 200 bp. The rally looks to have painted the majority of the CRT subordinate universe with a similar brush despite disparate credit and prepayment risk across different vintages and collateral profiles. For example, CAS 2020-R01 1B1 currently trades at a slight discount to par and roughly a 325 DM at the pricing speed of 10CPR. The collateral backing the bond is 4 WALA and has a 4.28% gross WAC and a weighted average LTV of 74. The bond has roughly 20 bp of credit enhancement and is 75 bp thick. By comparison, certain seasoned subordinate classes with less prepayment and credit risk can trade to substantially wider spreads. The B class of Freddie Mac’s inaugural actual loss deal, STACR 2015-DNA1 B, trades at roughly a $130-16 price and roughly a 425 DM. The bond is currently paying at a six month average of 10 CPR, in line with its pricing speed. The collateral backing the pool is 86 WALA, 3.65% gross WAC and has an FHFA HPI adjusted LTV of 50. The bond is the first loss class of the deal and is roughly 180 bp thick. While it is the first loss class, the loans backing the deal have experienced 1 bp of cumulative defaults to date, which for practical purposes likely eliminates the need to value the bond to a loss adjusted spread. Despite the 2015 deal having a substantially lower WAC, more seasoning and being significantly less levered both structurally and from a mark to market LTV perspective the bond trades at a substantially wider nominal spread. These types of risk based pricing inconsistencies should set up investors to be able to extract relative value from the sector.
Bonds backed by seasoned subordinates that were initially retained by the enterprises and bonds backed by off the run collateral like loans that were refinanced through their HARP program may offer some of the most attractive OAS and relative value. In an effort to gauge both convexity and credit OAS, Amherst’s home price projections are recalibrated to reprice home prices down 1% annually. Admittedly there is a low likelihood of this scenario being realized but it will help frame potential risk adjusted return across the sector. Based on this projection, the majority of the CRT subordinate universe trades at rough a 250 bp OAS with some significant outliers. The biggest outliers are bonds issued off Freddie Mac’s off the run FTR program and the enterprises HRP programs where they transfer risk on loans refinanced through the HARP program. (Exhibit 1)
Exhibit 1: Risk and return across the CRT subordinate universe
Freddie Mac’s 2019 FTR issuance is comprised of four transactions. The 2019-FTR1, FTR3 and FTR4 transactions are comprised of seasoned subordinate bonds that they retained at issuance. Prior to the issuance of the FTR deals, Freddie Mac removed delinquent loans from the reference pool, mitigating any existing underlying credit risk and effectively resetting a the CDR curve to zero. The FTR2 deal is backed by seasoned low and high LTV loans. From a credit perspective, seasoned subordinates should offer investors significant protection given deleveraging through prepayments, amortization and home price appreciation. And from a prepayment perspective, deals backed by HARP collateral have by and large been prepaying slower than on the run issuance and should offer investors better convexity than on the run transactions especially against the rally in interest rates. Fannie Mae is poised to launch their inaugural seasoned subordinate issuance, CAS 2020-SBT1. Despite the recent weakness in spreads, the deal should likely meet with significant investor interest given the relative value that seasoned transactions have shown to date.
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