By the Numbers
PLS positioning into a bull steepening
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.
The recent move in both rates and risk illustrated how different private label exposures may perform into a pronounced bull steepening of the yield curve. Shorter spread duration, more positively convex profiles such as RPL‘AAA’s and discount front sequentials and pass-throughs backed by agency-eligible investor loans appear poised to outperform against the backdrop of potentially elevated rate and spread volatility.
This latest drop in rates and sell off in risk had a disparate impact on different sectors of the private label market. Some sectors held up well against the volatility while others underperformed. Primary market spreads on deals backed by agency-eligible investor loans, scratch-and-dent collateral and residential transition loans fared better than deals backed by prime jumbo and non-QM loans. This week’s move impacted valuations in the secondary market as well. Spreads on premium cash flows, particularly more negatively convex 6.0% front sequentials backed by jumbo collateral and premium coupon non-QM ‘AAA’s experienced greater nominal spread widening than other exposures. In addition to a restriking of prepayment assumptions to faster speeds across these cohorts, investors are likely putting increased weighting on the probability that outstanding non-QM trusts backed by higher gross WAC collateral get called at the first 3-year optional redemption rather than the four year step-up pricing call.
Stacking up exposures
Modeling these cash flows broadly show that while all these exposures are generally short duration, they have varying degrees of negative convexity. Discount investor bonds, RPLs and scratch-and-dent ‘AAA’s by and large are less negatively convex and exhibit lower option cost than other short duration private label exposures. Investor 5.5% pass throughs and RPL ‘AAA’s carry the most base case duration at roughly 3.5 years. RPL ‘AAA’s are substantially less negatively convex than investor pass throughs despite being more structurally levered due to the modified, low WAC, highly seasoned nature of the collateral. Scratch and dent ‘AAA’s exhibit a similar convexity profile to RPLs even though these pools are generally collateralized by always performing loans which, for some reason or another, were either not deliverable to agency execution or were repurchased out of MBS trusts due to potential defects in underwriting.
Screening for Total Return
An analysis of these cash flows over instantaneous parallel and non-parallel shocks of the yield curve shows that in a 50 bp bull steepening of the yield curve, RPL AAA’s offer the best total return prospects. 5.5% pass throughs and front sequentials backed by investor collateral offer attractive total return as well (Exhibit 1). Based on the analytical framework, which hold OAS constant, non-QM AAAs appear to offer some of the best total return prospects. However, a bull steepening of the yield curve would be commensurate with lower front end benchmark rates. A re-steepening of the yield curve in this manner creates substantial incentive for sponsors of non-QM trusts to re-lever outstanding liabilities at the first call date given that the ‘AAA’ through ‘A’ rated pro-rata portion of the capital structure is struck off a two-year benchmark rate. As evidenced in price action this week, the pulling forward of callability assumptions should drive both nominal and option adjusted spread widening in these cash flows on premium bonds, capping dollar prices into a rally, which is not reflected using a constant OAS framework.
Exhibit 1: Total return across PLS exposures
Source: Santander US Capital Markets, YieldBook as of 8/8/24 closing curve and end-of-day pricing.
Leveling the playing field.
While illustrative to look at on a stand-alone basis, clearly longer duration exposures will have the advantage of greater price appreciation into a rally than shorter ones. Given this, all exposures are normalized on a duration- and proceeds-neutral basis to a 2.5-year base case effective duration. Exposures with modeled durations shorter than 2.5 years are combined with a basket of 10-year Treasury notes to achieve equivalent duration. Conversely, exposures with longer durations are combined with one-month Treasury bills to normalized duration.
Upon normalizing for both duration and proceeds, RPL ‘AAA’s and both longer front sequential cuts and pass-throughs with 5.5% coupons backed by agency-eligible investor collateral offer the highest total return into a bull steepening of the yield curve (Exhibit 2). These bonds also offer a total return advantage over other exposures to parallel shifts lower in rates. Jumbo transaction that priced this week have shown some spread widening versus deals backed by investor collateral. However, it appears that the convexity afforded to investors in the form of both far lower average loan size than jumbo as well as a substantially more lagged response to refinancing incentive in investor collateral is still mispriced to some degree. Given this, the potential for total return from these cash flows may be even better than forecasted if demand for call protection increases and spreads tighten across these bonds.
Exhibit 2: RPL, investor outperform into a bull steepening
Source: Santander US Capital Markets, YieldBook as of 8/8/24 closing curve and end-of-day pricing.
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