By the Numbers
To call or not to call non-QM deals
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.
Sitting at a weighted average price close to par, the universe of collateral backing non-QM trusts appears to be rapidly approaching a point of maximum negative convexity. Prospects for total return upside to a further rally and steepening of the curve will be driven by bonds’ ability to hold duration into a rally. Deals that have not substantially de-levered backed by sponsors with limited history of calling deals may offer investors with the most price upside.
Estimating duration of non-QM exposures is historically tricky given the presence of short-dated issuer calls struck at par. Perceived inefficiencies of issuer calls based solely on the price of the collateral relative to the par strike are borne of the fact that the decision to call or not call a deal is a multivariable analysis. Several factors will weigh on a sponsor’s decision to call in varying degrees. Some of these factors are:
- The level of moneyness of the collateral relative to the par strike.
- A deal’s effective advance rate and cost of funds relative to current term financing levels.
- Potential duration hedging the call with payer swaptions.
- Changes in the effective strike from retaining discount bonds at issuance.
The interplay between collateral price and cost of funds is likely the biggest driver of the decision whether to call a transaction or not. For example, certain collateral pools originated and securitized in 2021 may be trading well above par. However, there is likely significant disincentive for the issuer to call given the historically low level of both benchmark rates and spreads relative ton where the sponsor would have to re-securitize those loans today and would likely make the outstanding liabilities stickier than a deal with comparable collateral price issued in prior periods with a higher cost of funds.
Reshaping the curve drives securitization economics
Years of yield curve inversion have been a thorn in the side of aggregators and issuers of non-QM securitizations as the overwhelming majority of the Non-QM capital structure sits on the front end of the curve while note rates on the majority loans backing these deals are struck off the longer dated part of the yield curve. The shape of the yield curve over the past two years has manifested in not only elevated cost-of-funds to issuers but a corresponding cram down in excess spread as well (Exhibit 1). Lower absolute rates are pushing collateral prices higher while the re-steepening of the yield curve is driving a lower cost of funds and increasing excess spread. The confluence of these factors is translating to elevated call risk across certain segments of the market.
Exhibit 1: Excess spread grows in Non-QM trusts
Source: Santander US Capital Markets, KBRA
Pricing the Universe
Employing a few simplifying assumptions for both discount and prepayment rates suggests that the roughly $105 billion of outstanding collateral backing non-QM trusts is trading at a slight discount to par, roughly $99.3. What may not be broadly appreciated is that the outstanding universe is almost equally bifurcated around par. Deals whose collateral prices below par total just over $53.2 billion with a weighted average price of $92 while the universe that trades at or above par totals $53.5 billion with a weighted average price of just over $106.5 (Exhibit 2).
Exhibit 2: Non-QM universe equally distributed around par
Source: Santander US Capital Markets, CoreLogic LP, Intex Note: Priice derived using a constant discount rate of 6.5% at average 3M trailing CPR
One substantial caveat to this analysis is that while the universe straddles par, a significant portion of the premium cohort is backed by more recent issuance that is not immediately callable and while prepayment related negative convexity will still weigh on these bonds ability to hold duration into a rally, prices will not be further capped by near term callability. Collateral pools trading in excess of a five-point premium to par are almost exclusively 2023 and 2024 vintage pools. Conversely, much of the 2020 vintage is currently trading near or above par and is currently callable. Discounted mezzanine and subordinate bonds backed by certain 2020 vintage deals look to have substantial optionality to pull to par at call but investors may consider a transaction’s sponsors call history when evaluating optionality.
Stacking up sponsors call history
Anecdotally, the market skews a greater probability of deals being called by sponsors that need to return or recycle capital such as alternative asset managers or private credit funds while it puts a lower likelihood of a deal being called by permanent capital vehicles such as REITs. And while there is certainly precedent to support this anecdote it is likely not absolute (Exhibit 3).
Exhibit 3: Call activity by NQM sponsor
Source: Santander US Capital Markets, CoreLogic, LP, Intex
Permanent capital sponsors such as Rithm Capital have NRZT deals in the past. Other sponsors such as Ellington Management (EFMT), Angel Oak (AOMT), and TPG Angelo Gordon (GCAT) maintain permanent capital vehicles call transactions as well. Given this, the anecdotal belief that permanent capital vehicles are disincentivized to call deals as long as the levered returns are sufficient to support dividends may be flawed and there may be sufficient near term incentive to call seasoned de-levered deals and re-lever the remaining collateral.
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