By the Numbers
Benchmarking residential credit risk and return
Chris Helwig | May 21, 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.
Investment grade exposures to residential credit have offered better risk-adjusted returns than investment grade corporate exposures since March of last year. Non-investment grade residential credits, however, have fared worse than their corporate counterparts. It is not just about credit, of course. Embedded interest rate and spread exposures as well as liquidity vary across securities as well. They all contribute to performance.
Within residential credit alone, other important factors shape performance. Structural differences across cohorts will create differences in both interest rate and spread duration for bonds with similar rating across different sectors of mortgage credit. Given this, comparable amounts of spread widening or tightening across different sectors of the market will have different impact on comparably rated bonds or relative to a corporate benchmark. Additionally, mezzanine and non-investment grade credits across certain sectors, like RPLs, will trade with substantially more interest rate duration than other sectors as a function of both structure and the duration associated with the low WAC, modified loans collateralizing these deals. Given the fact that these are absolute and not excess returns, instruments with greater amounts of rate exposure have likely exhibited greater volatility of returns given the rally and subsequent sell off in rates over the past year.
While there may be substantial differences in rate and spread duration further down the capital structure, ‘AAA’ cash flows generally exhibit smaller variances in duration than those further down the capital structure. Since March, non-QM and RPL ‘AAA’ classes have offered comparable risk adjusted returns, with both cohorts substantially outperforming prime ‘AAA’. Returns in RPL, and to a lesser extent, non-QM ‘AAA’ were bolstered by a slowdown in speeds despite the rally in interest rates as both cohorts saw experienced a significant spike in forbearance-related delinquencies which dampened prepayment rates. Conversely, price returns on prime ‘AAA’ were likely capped as extremely elevated prepayments caused these bonds to trade with very little rate duration into the rally (Exhibit 1).
Mezzanine investment grade credits in non-QM offered the best risk-adjusted returns across investment grade mortgage credit since March of last year with both ‘A’ and ‘AA’ rated cash flows posting Sharpe ratios close to 1.0, providing significantly better risk adjusted return than a benchmark of investment grade corporates. The prospects for elevated risk-adjusted returns in pro-rata mezzanine classes of non-QM deals are likely not as strong going forward though. Delinquency rates have fallen sharply, which should increase call risk in seasoned deals and prepayment rates have risen across the cohort, increasing negative convexity and likely putting a ceiling on price returns as a result. Additionally, given the pro-rata nature of the top of the capital structure in non-QM, these bonds do not benefit from rolling down the spread curve as deals deleverage, unlike investment grade mezzanine bonds in RPL structures.
Exhibit 1: Risk and return across investment grade mortgage credit
Mezzanine investment grade credits in prime securitizations and CRT last cash flows also posted better risk-adjusted returns than an investment grade corporate benchmark since March. Despite a shifting interest structure employed in prime securitizations, these bonds may continue to benefit from continuing to build credit enhancement as elevated prepayments continue to deleverage these deals. If prepayments outpace cure rates in prime securitizations, it may cause delinquency rates to remain elevated, locking out mezzanine and subordinate bonds, a phenomenon observed in CRT. However, this lockout will cause these deals to continue to build credit enhancement, potentially expanding loss coverage multiples and tightening spreads across the mezzanine portion of the capital structure in prime securitizations.
Risk-adjusted returns since March of last year on non-investment grade exposures to mortgage credit universally underperformed a high yield corporate benchmark and, in some cases, materially underperformed. Across the spectrum of exposures, non-QM ‘B’ rated bonds fared best, as they posted a relatively modest negative return of 12.2% in March of last year, roughly in-line with the high yield benchmark. ‘BB’ and ‘B’ rated prime credits and most forms of subordinate CRT exposure have posted comparable risk-adjusted returns despite substantially different monthly return profiles since thin onset of the pandemic (Exhibit 2).
Exhibit 2: Risk and return across non- investment grade mortgage credit
While non-investment grade prime subordinates will have greater exposure to any tail of borrowers who are not able to re-perform as forbearance plans come to an end, they should benefit from the same type of deleveraging and expansion of loss coverage multiples that should drive spreads tighter in the investment grade mezzanine portion of the capital structure. The pronounced rally in CRT last month suggests that much of the upside to slower speeds on premium subordinates and higher than anticipated cure rates on loans exiting forbearance may be priced in at this point, but locked out CRT subordinates should still benefit from being a relatively long spread duration asset that can roll down a relatively steep credit and interest rate curve.