A wide menu of risk and return in Ginnie Mae project loan IO
admin | April 23, 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.
Most securitizations of Ginnie Mae project loans include an interest-only class, but these are not the same kind of IO that come out of the residential or other parts of the commercial MBS markets. Project loan IO get interest from underlying loans, but they also get prepayment penalties. The combination of these cash flows leads to distinct profiles of risk and return. One deal might spin off IO with negative duration and negative convexity, and the next deal might offer IO with positive duration and positive convexity. The sector ends up offering a wide set of potentially valuable choices for managing debt portfolios.
Different cash flows, different risk profiles
Project loan IO get their interest from fully amortizing fixed-rate loans with 35- to 40-year maturities. The IOs also receive prepayment penalties due when borrowers refinance or terminate their loans early. Penalties are assessed as a percentage of the outstanding balance. After a lockout period, typically one year in today’s market, the penalty commonly starts at 10% and declines to zero by the tenth year of the deal.
The value of project loan interest cash flow should broadly behave like traditional residential MBS IO. As rates fall, faster prepayments drive down the principal balance available to pay interest. The prospect of falling interest cash flow, despite lower discounting rates, should drive down the IO price. As rates rise, slower prepayments increase projected future principal balance and interest cash flow, raising the price of the IO. This pattern of IO prices rising and falling as interest rates rise and fall creates negative duration and, typically, negative convexity.
The value of project loan penalty cash flow behaves very differently. As rates fall, faster prepayments drive up the flow of penalties, raising the value of the penalty cash flow. And as rates rise, slower prepayments reduce projected penalty cash flows, lowering the value of the penalty cash flow. The pattern of penalty cash flow value moving in the opposite direction of rates creates positive duration and, often, positive convexity.
Where project loan IO get most interesting, it is because of the changing proportion from one IO to the next of cash flow coming from interest and penalties. If interest cash flow predominates, the IO skews toward negative duration and negative convexity. If penalty cash flow predominates, the IO skews toward positive duration and positive convexity.
Examples from new Ginnie Mae project loan IO
Project loan IO coupons can have a really broad range, depending on the gross weighted average coupon of the collateral, the structure of the deal and investor demand. During 2020 there were 90 project loan deals with IO classes, and the coupons ranged from 0.45% to 1.63%, though the majority of the coupons fell between 0.90% to 1.10%. This intermediate coupon range roughly balances the projected value of the interest strip with the value of the penalty stream at the market standard prepayment speed of 15 CPJ, which is 15 CPR and 100 PLD. The recently issued GNR 2021-11 IO, for example, at 15 CPJ gets 56% of its cash flow from interest and 44% from penalties (Exhibit 1).
Exhibit 1: Projected cash flow on GNR 2021-11 IO at 15 CPJ
The proportion of cash flow coming from interest and penalties can vary significantly across project loan IO and across projected prepayment speeds. As noted, GNR 2021-11 IO with a 1.02% coupon at 15 CPJ gets 56% of its cash flow from interest and 44% from penalty (Exhibit 2). In contrast, GNR 2020-145 IO and its lower 0.73% coupon at 15 CPJ gets only 46% of its cash flow from interest and 54% from penalty. These IOs, in turn, contrast with GNR 2021-34 IO with its high 1.56% coupon where, at 15 CPJ, it gets 64% of its cash flow from interest and 36% from penalty. As CPR goes up and down, the share of cash flow coming from interest and penalty shifts for each IO, but the ranking of cash flow share coming from interest and penalty is steady across IO: the low coupon IO always gets the lowest share of cash flow from interest, the middle coupon gets the middle share and the high coupon gets the highest share.
Exhibit 2: Interest and penalty share of cash flow varies by IO and by CPR
The differences across project loan IO and their potential roles in a portfolio become even clearer when the cash flows get translated into traditional risk and return metrics. Quick observations (Exhibit 3):
- Project loan IO with lower coupons and a higher proportion of potential cash flow from penalties instead of interest tend to show positive duration and positive convexity while higher coupons skew toward negative duration and negative convexity
- Considering their estimated duration, project loan IO tend to trade at relatively high yield and high OAS, compensation for their high sensitivity to changes in prepayment patterns as well as limits to liquidity
Exhibit 3: Risk and return estimates on selected newer Ginnie Mae project loan IOs
Relative value and portfolio roles for Ginnie Mae project loan IO
Benchmarking relative value in Ginnie Mae project loan IO goes beyond comparing one IO to the next on coupon, projected prepayments and defaults, dispersion in note rates and penalties across loans, deal structure and so on. Difference in interest and penalty cash flow and consequent relative duration and convexity create profiles best compared to other products offering similar duration and convexity. Positive duration project loan IO should compete against other positive duration assets, negative duration against IO from other assets or against other ways of short-selling the rates markets. Given their relatively wide spreads, project loan IO should look very competitive.