By the Numbers
Relative value in short-duration RMBS
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. This material does not constitute research.
Non-QM ‘AAA’ classes in RMBS appear to have some additional room to tighten, but discount RPLs and front sequential classes backed by prime collateral may provide both attractive spread with greater total return upside into a rally.
Current relative value in short-duration RMBS includes a few highlights:
- Non-QM ‘AAA’ have room to tighten against short corporate debt
- Certain discount ‘AAA’ RPL classes should get a lift from relatively fast prepayments
- Discount 5.5% MBS backed by investor loans should do well in a bull steepening
- The OAS on non-QM ‘AAA’s likely tops the OAS on closed-end second ‘AAA’ classes
Spread and weighted average life
Investors in ‘AAA’ private-label RMBS have options when looking for exposure to the front end of the yield curve. Non-QM seniors remain the most consistent source of supply, however investors can add meaningful exposure in second liens, re-performing and scratch-and-dent loans and front sequential cash flows backed by prime jumbo and agency-eligible investor collateral. Spreads for short duration ‘AAA’ exposures range from roughly 120 bp to just inside of 200 bp. (Exhibit 1)
Exhibit 1: New issue spreads across short-duration RMBS
Source: Santander US Capital Markets, Bloomberg LP
Non-QM approaching fair value but some room to tighten further
Newly issued ‘AAA’ classes of non-QM securitizations are trading at roughly 130 bp with some variance across issuers. At current valuations, new issue bonds are trading roughly 10 bp inside of their 5-year average spreads, are roughly 80 bp wider than investment grade benchmarks and 15 bp tighter than current coupon agency MBS nominal spreads. The relationship between ‘AAA’s, investment grade corporate and MBS spreads shows that at roughly 80 bp ‘AAA’s are 15 bp wider than the long term average basis between non-QM and the corporate benchmark, and at -15 bp non-QM AAAs are currently 30 bp inside of the average basis between non-QM and current coupon MBS (Exhibit 2).
Exhibit 2: Non-QM, corporate and current coupon MBS spreads over time
Source: Santander US Capital Markets, Bloomberg LP
Looking at the historical relationships between non-QM ‘AAA’s, corporates and MBS shows that the benchmark for relative value can be a moving target and investors may weigh the relationship to corporates or MBS differently based on a few variables. The primary factor that appears to drive whether non-QM spreads are primarily benchmarked against corporates or MBS is the expected duration of the ‘AAA’ cash flow. Shorter duration ‘AAA’s are more likely to be viewed as surrogates for short corporates while longer duration, less callable non-QM seniors are more likely to be benchmarked against MBS and require more nominal spread compensation given the benchmark. This is evident when mapping the duration of non-QM ‘AAA’s against the basis between their spreads and current coupon MBS, where, as the duration of non-QM ‘AAA’s extended into the backup in rates, investors commanded a greater premium over the MBS benchmark (Exhibit 3). Given forward mortgage rates implied by the inverted yield curve, investors in ‘AAA’ classes of non-QM likely see the asset as callable and relatively short duration, skewing the relative value benchmark toward short corporate exposures.
Exhibit 3: Non-QM spreads widen as ‘AAA’ duration extends
Source: Santander US Capital Markets, Bloomberg LP
RPLs – they’re back
After a sustained hiatus, a steady stream of securitizations backed by re-performing collateral have returned to the market. The resurgence of RPL deals has been spurred by two factors. First, pent up supply of RPLs from banks that held on to these loans against exponential deposit growth during the pandemic has begun to change hands to sponsors of RPL securitizations. And after a pause last year mandated by the Federal Housing Finance Agency, the GSEs have resumed bulk sales of RPLs. Second, loans that have been repurchased by originators from the GSEs are being securitized in scratch-and-dent deals, although in many cases the loans being securitized have always performed.
Historically, relative performance in RPLs has been driven by selecting deals more likely to prepay faster than others. One metric that has historically been a reliable predictor of prepayment rates is the amount of forbearance that modified loans carry. Elevated levels of principal forbearance reduce the effective WAC on the collateral, generally leading to slower prepayment rates. This is evident when looking across RPL deals issued on the Towd Point shelf, one of the largest RPL issuers. (Exhibit 4)
Exhibit 4: Deals with lower levels of principal forbearance have prepaid faster
Source: SanCap, Bloomberg LP
Given this, investors in discount ‘AAA’ classes should look to deals with lower amounts of forbearance that are likely to have greater upside to pulling to par. RPL investors at the top of the capital structure may have additional optionality to pulling to par as certain recent transactions have introduced short-dated call options and options for the sponsor to execute bulk sales from the pool that would drive elevated prepayments.
Front sequentials stand out in jumbo and investor
Looking across structure in prime RMBS, front cash flows look to offer the best relative value. This week’s drop in interest rates has driven prices on the majority at or through par and likely shifted the relative value landscape to some extent. Benchmarking relative value using OAS per unit of duration suggests that 6.0% front cash flows backed by both jumbo and investor collateral offer the best relative value, while premium 6.5% coupon cuts are trading much tighter on an OAS basis. For investors looking to add front-end key rate duration with convexity to position for a bull steepening of the yield curve, discount 5.5% sequentials or pass-throughs will likely hold their duration better, and subsequently generate better price return, than both bonds backed by jumbo or Non-QM collateral given the greater negative convexity in jumbo and limited premium upside due to callability in Non-QM. (Exhibit 5)
Investor collateral has, at a minimum, historically shown a slower response to the same amount of refinancing incentive as other prime loans and, all else equal, should provide greater call protection into a rally. Slower refinancing response is generally driven by that easier to refinance owner-occupied loans will be targeted by originators first. Investors looking for front end exposure but somewhat longer duration alternatives should target 75% front sequential cash flows and non-NAS affected pass-throughs.
Exhibit 5: Front sequentials offer the best OAS per unit of duration
Source: SanCap, Yieldbook, Bloomberg LP
Second liens get the call
Recent securitizations backed by closed-end second lien (CES) collateral have removed structural features that used a portion of the deal’s excess spread to de-lever senior bondholders, instead making the senior cash flows structurally shorter through the introduction of a date call and step-up coupon on senior fixed-rate bonds, akin to current non-QM structures.
The introduction of a date call changes how investors may be valuing these cash flows, particularly versus non-QM ‘AAA’s with similar call and step-up features. Assuming the roughly same nominal spread of 130 bp on non-QM and CES ‘AAA’s the effective option cost may be higher and OAS lower on CES ‘AAA’s simply as a result of the fact that the par call on CES transactions is much deeper in-the-money given the underlying loans trade at prices between $106 and $107 versus $102 to $103 for Non-QM collateral. However, this could be offset to some degree by greater prepay variability in non-QM loans.
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