By the Numbers
Extracting Total Return from Reperforming Loans
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.
Given rising concern about prepayment risk, investors should take a close look at securitizations backed by reperforming loans (RPLs). The combination of structure and collateral offer attractive hedge-adjusted total returns partly because of limited prepayment volatility and partly from a tendency to improve in credit protection as the deals season and de-lever. Deals with smaller amounts of securitized principal forbearance and those with larger concentrations of ARM loans generally offer investors the most upside to deleveraging through faster prepayments.
Private-label securitizations backed by reperforming loans have provided investors with a generally stable and predictable source of total return for several years. RPL deals are mostly collateralized by seasoned, modified loans with below-market coupons and substantial equity. The combination affords investors both stable prepayments and solid credit fundamentals, which translate to mezzanine and subordinate classes rolling down a fairly linear credit curve and in many cases being upgraded as the deals de-lever. Sequential RPL structures provide mezzanine and subordinate investors with substantial spread duration, and rolling down the credit curve translates to meaningful price appreciation. Discount RPLs should have additional total return upside given the potential to pull to par if the issuer calls the transaction.
Speeding in the RPL lane
One critical dimension to extracting total return in seasoned RPLs if finding deals that offer consistent but relatively elevated prepayment rates. One collateral attribute that has historically predicted relatively fast speeds is the amount of securitized forbearance in the transaction. RPL deals are somewhat unique in that they include both performing ant non-performing balances. Non-performing balances consist of principal forbearance created through a loan modification where some portion of the original principal balance of the loan is appended to the maturity of the loan and does not accrue interest. Principal forbearance reduces the effective WAC to an average rate of the stated WAC for the performing balance and a zero WAC for the forborne amount. Using one of the largest and most frequent issuers of reperforming loan securitizations, Towd Point, shows the inverse relationship between forbearance and prepayment rates (Exhibit 1)
Exhibit 1: Lower forbearance translates to faster speeds in seasoned RPLs
Source: Santander US Capital Markets, CoreLogic LP, Intex Solutions
In addition to deals with lower amounts of principal forbearance, ARM collateral tends has historically prepaid faster than fixed-rate loans in seasoned RPLs. Over the past two years, ARM loans securitized in RPL trusts have prepaid roughly 8 CPR faster than fixed rate loans. ARM loans have prepaid between 9 and 15 CPR while fixed rate loans have ranged from 5 to 7 CPR on average (Exhibit 2).
Exhibit 2: Reperforming ARM loans prepay faster than fixed rates
Source: Santander US Capital Markets, CoreLogic LP Shelves analyzed include CSMC, GSMBS, JPMMT, MCMLT, TPMT
Forecasting total return
Estimated base case, unhedged total returns range from just under 5% to slightly more than 6.5% for AAA through single ‘B’ classes of RPLs. RPLs across the capital structure will outperform into a bull steepening of the yield curve and AAA classes specifically should hold their duration better and generate better total return than other open window Private-label exposures given the better convexity profile.
The sequential RPL structure generally lends itself to a fairly linear credit curve. RPLs spreads generally increase by 20-25 bp per rating category. Given this, potential total return upside from deleveraging can be forecasted by tightening spreads by first solving for base case OAS and then tightening OAS across the capital structure by 25 bp. Admittedly, this may overstate potential price upside to some extent as, depending on an individual deal’s prepayment rate it may take longer than a year for bonds to roll down to the bonds to build credit enhancement consistent with original enhancement levels of the bond above it. However, absent a material deterioration in performance or a broad-based widening in credit spreads, RPL bonds across the capital structure, even inclusive of AAA classes, generally tighten as the deal seasons.
Based on this methodology, forecasted base case total returns increase by anywhere From 52 bp to 2.62% across the capital structure with non-investment grade classes offering the greatest return upside given their longer spread duration (Exhibit 3).
Exhibit 3: Spread tightening related total return across modeled scenarios
Source: Santander US Capital Markets, Yieldbook
While the RPL structure provides investors with substantial spread duration, the combination of structure and collateral creates substantial rate duration particularly in locked out mezzanine and subordinate classes of these transactions. As a result, RTL returns should be viewed on a hedge adjusted basis. Each class of the deal is rate hedged with a blend of Treasuries. More senior classes of the transaction are hedged with a blend of 3-year and 10-year notes while deeper mezzanine and subordinate bonds are hedged with a combination of ten and twenty-year Treasuries. Base case hedge adjusted returns range from 1.62% to 2.56%.
Exhibit 4: Stacking up hedge adjusted returns across the capital structure
Source: Santander US Capital Markets, YieldBook
RTL bonds across the capital structure can deliver relatively stable hedge adjusted returns as modified loans are generally substantially seasoned and exhibit prepayment burnout as a result of that seasoning. Limited volatility of prepayments and duration translates to lower delta hedging costs, which should be increasingly valuable to investors given heightened prepayment risk in other Private-label exposures.
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