By the Numbers
Passing the return baton from CRT to non-QM 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.
Certain exposures to residential credit have delivered strong absolute and risk-adjusted returns in the last few years compared to investment grade or high yield corporate benchmarks. CRT has the been among the best sources of good returns. While the CRT performance could be hard to repeat, the baton may go to non-QM seniors and subordinate classes for providing strong out-of-index risk-adjusted return.
Strong fundamentals behind mortgage credit, wider spreads than corporates
A handful of factors appear to be making MBS broadly and residential credit specifically better value than corporate exposures. The strength of the US consumer relative to corporate balance sheets is the biggest driver, particularly against the backdrop of weaker corporate earnings. Spreads also play a role as portions of the investment grade term curve are at or near 5-year tights. One additional factor is historically better risk-adjusted returns over both 1- and 3-year horizons. Of course it’s not all about credit. Both rate and spread duration will drive relative risk-adjusted returns as will relative liquidity across asset classes.
Trailing returns across investment grade mortgage credit
Splitting the universe of mortgage credit into senior, mezzanine and subordinate risk, a few things become clear in looking at trailing performance. CRT mezzanine classes—bonds at the top of the capital structure that carry investment grade ratings—have provided the best risk-adjusted return with a Sharpe ratio near 1.0 (Exhibit 1). Those returns reflect some element of both credit risk and structural leverage. For investors that require the liquidity and lower credit risk of ‘AAA’, non-QM seniors have provided the best risk-adjusted return. Non-QM ‘AAA’ have also performed better than a broad index exposure to investment grade corporate debt. The notable commonality between exposures that have outperformed is they generally show low duration.
Exhibit 1: Risk adjusted returns across residential credit seniors, investment grade benchmarks
Source: Santander US Capital Markets, IDC, Intex, CoreLogic LP, Yieldbook. Monthly total return calculated as monthly price change, interest income, and discount par principal accretion net of principal loss.
One caveat to this analysis is that these are absolute and not excess returns after netting out returns from duration. Bonds across these sectors can show different interest rate and spread duration despite similar rating. Trailing returns will reflect these differences in rate and spread duration as well as the differences in credit.
Another caveat is liquidity or price transparency. Price transparency in CRT is comparable to corporate credit, with frequent trades on TRACE. However, other sectors of the residential market may not trade with the frequency or transparency of corporates or CRT, potentially understating price volatility and overstating risk-adjusted returns.
Trailing returns across speculative grade mortgage credit
Across mezzanine and subordinate exposures, CRT subordinates stand out. For the purpose of this analysis, this includes CRT issued as non-investment grade or unrated bonds. These instruments have provided better absolute average monthly returns than any other mortgage credit exposure as well as better absolute and risk-adjusted returns than a broad market high yield exposure over 1 and 3-year horizons. The advantage in CRT subordinates may be magnified since price volatility is based on monthly and not daily pricing. Monthly pricing misses intra-month volatility, which should be elevated relative to other residential exposures given greater relative liquidity and price transparency in CRT relative to other cohorts (Exhibit 2).
Exhibit 2: Stacking up risk-adjusted returns across mezzanine and subordinate exposures
Source: Santander US Capital Markets, IDC, Intex, CoreLogic LP, Yieldbook. Monthly total return calculated as monthly price change, interest income, and discount par principal accretion net of principal loss.
Past and potential future returns
While CRT mezzanine and subordinate bonds have exhibited the best historical absolute and risk-adjusted returns, there may be limits to repeating this performance for a handful of reasons. Specifically:
- CRT spreads have tightened substantially over the last year and may have limited room to tighten further.
- Further tightening in CRT mezzanine bonds may be capped as exposures at the top of the issued capital structure are currently trading at spreads where they cannot be efficiently levered.
- A drop in interest rates may drive a spread widening as investors command compensation comparable to current unlevered yields.
- Issuance of subordinate classes is becoming increasingly scarce, making it difficult to scale a large exposure.
- Finally, as more of the seasoned, longer-spread-duration subordinate classes de-lever or are tendered, it is increasingly difficult to gain material spread duration in CRT subordinate classes, potentially limiting price return.
Looking across other non-investment grade exposures, non-QM subordinate bonds have provided the highest average monthly return over the past year. The prospects of repeating a strong performance seem substantially better for non-QM subordinate and equity classes, which look likely to tighten given potential compression in equity yields that would likely be commensurate with a rally in benchmark rates.
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