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Call risk puts a cap on non-QM MBS returns

| January 29, 2021

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.

Low interest rates, tightening debt spreads and falling delinquencies have materially increased the callability of non-QM trusts. Non-QM issuers usually have the right to call the loans and collapse the trusts after a few years. Investors consequently should be wary of bonds backed by non-QM loans that trade at a premium to par. There may be little upside to tighter spreads, especially in locked-out, lower-rated mezzanine classes likely to be called at par at their first call date.

Delinquency rates in non-QM loans continue to fall month-over-month while the recovery has stalled in most other cohorts. Delinquencies have dropped by more half from peak levels, currently sitting at less than 12% after hitting a peak in June of nearly 24% (Exhibit 1). This pronounced credit curing, along with other factors, has driven the average price of loans backing non-QM trusts above par for virtually the entire universe of non-QM trusts.

Exhibit 1: A pronounced recovery in non-QM credit

Source: CoreLogic, Amherst Pierpont Securities

In addition to credit curing, spreads have tightened across the credit curve in non-QM debt, giving issuers incentive to call outstanding deals and re-securitize the loans at a lower cost of funds. An analysis of a recently issued non-QM deal, VERUS 2021-R1, which priced on January 13, shows that the sponsor achieved a 98.5% advance rate at a weighted average spread of 82 bp. Assuming an average life of 2.32 years, the deal implies an all-in cost of funds of just 1.03% at the current level of rates. (Exhibit 2)

Exhibit 2: Historically low COF incentivizes sponsors to call non-QM trusts

Source: Bloomberg LP, Amherst Pierpont Securities

Lower delinquencies and lower funding costs would mean little if the collateral backing non-QM trusts is worth less than the par price at which sponsors can call these deals. However, an analysis of roughly 100 outstanding non-QM trusts suggests that the collateral backing virtually the entire universe of deals is trading points above par, even when assuming a conservative discount rate of 3.0% on the loans compared to a current liability yield of just over 1.0% (Exhibit 3). Even before accounting for issuer calls, the duration of the collateral underlying non-QM trusts is short as a result of forecasted elevated prepayment rates. This highlights the fact that investors should be wary of premium risk even absent issuer calls as the collateral is likely to exhibit fast prepayments especially against the backdrop of falling delinquencies.

Exhibit 3: The universe of non-QM collateral prices well through par calls

Source: Amherst Pierpont Securities Note: Assumes a 3% yield to price to maturity

Call risk has already started to show up on the front step of non-QM investors. The January remittance saw a total of five deals called, and it appears an additional 12 deals totaling $1.3 billion in collateral UPB could be called next month. Absent a material increase in interest rates, call risk appears likely to remain front and center for non-QM investors throughout the remainder of this year and beyond (Exhibit 4). Obviously, the collateral balance at risk of being called at par will decline on deals with longer dated calls, however, absent scheduled amortization, that decline will be a result of prepayments, creating somewhat of a zero-sum game, particularly on current-pay premium bonds.

Exhibit 4: Estimating the timing of non-QM issuer calls

Source: Bloomberg LP, Amherst Pierpont Securities

Deals that appear to be at risk of call in the near term include Deephaven (DRMT) deals issued between 2017 through early 2019. One caveat is that these deals by and large exhibit substantially higher delinquency rates than the broader non-QM cohort, which may provide somewhat of a deterrent to the sponsor calling the deals at their next call date despite an estimated collateral price above par. Additionally, the more seasoned deals have paid down considerably, potentially creating less incentive for the sponsor to call these. Conversely, better performing deals issued in 2018 and 2019 by sponsors such as Caliber (COLT), Neuberger Berman (HOF), Oaktree (BHLD) and Seer Capital (RMLT) as well as some others, appear likely to be called in the coming months.

Ultimately it appears there is a significant amount of negative convexity embedded in non-QM trusts as a result of both short-dated call risk and rising prepayment risk. This negative convexity will in all likelihood cap total return that investors may be looking to extract from the asset class as price upside may be limited given the lack of ability for investors, especially those in lower-rated mezzanine classes of these deals, to benefit from spread tightening associated with rolling down the credit curve. Given the steady improvement in fundamentals coupled with a historically low cost of funds, it seems likely that sponsors will execute in-the-money calls on the overwhelming majority of non-QM trusts.

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