By the Numbers
Steady cash flows enhance relative value in second-lien MBS
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 sectors in structured products have started looking attractive compared to short investment grade corporates. But when valuing MBS against corporates, convexity and option cost matter. Senior cash flows backed by closed-end second liens offer both relatively stable cash flows and straightforward analysis of deal callability. The combination of relatively wide nominal spreads and low option cost should make these bonds one of the most attractive options for investors looking to outperform short investment grade benchmarks.
With investment grade benchmark indices trading near 5-year tights, certain private-label and ABS exposures appear poised to tighten this year as they likely attract crossover corporate buyers. While offering substantially more nominal spread than investment grade corporates, better relative value will ultimately come from cash flows with a relatively stable profile both in terms of prepayments and cash flow duration. That should skew value toward bonds backed by collateral that offer both a relatively flat prepayment S-curve and are substantially in-the-money on the deal call, which collectively should reduce option cost given limited prepayment volatility and mitigate potential extension risk if deals are not called.
Closed-end second lien prepayments mirror loan balance
The majority of collateral securitized in closed-end second lien (CES) transactions has drawn comparison to conventional conforming first liens with lower loan balances. And to date, prepayment S-curves on loans securitized in recent vintage CES deals have been relatively flat and mirror those of conventional loan balance collateral (Exhibit 1). While the shape of the S-curve is similar to conventional loan balance, absolute speeds for CES collateral are substantially faster than conventional loan balance given the same level of refinancing incentive. The additional caveat to the below is the absence of deep in-the-money observations, particularly where a drop in rates would create incentive to fully refinance the existing first and second lien balances, likely driving an asymptotic spike in prepayments for the CES cohort.
Exhibit 1: CES S-curves flat but faster than conventional loan balance
Source: Santander US Capital Markets, eMBS, Fannie Mae, Freddie Mac, CoreLogic LP Observations are Jan 2023 through December 2024 with all cohorts controlled for seasoning of no less than 12 and no greater than 36 WALA to control for the effect of both ramping and burnout.
Stacking up prepayment profiles across shelves, originators
Prepayment behavior across loans securitized in the largest CES programs is broadly consistent with a few exceptions. Looking across Cerberus’ TPMT, PIMCO’s BRAVO, Woodward Capital’s RCKT and Saluda Grade’s GRADE shelves shows that both nominal speeds and the shape of prepayment S-curves are, for the most part, consistent across the programs. Cerberus’ TPMT program exhibits the flattest S-curve with deeper out-of-the-money speeds in the low double digits while borrowers with 100 bp or greater of incentive prepaid in between 16 and 19 CPR. Out-of-the-money speeds on the BRAVO shelf were depressed relative to others, generally driven by a lack of observations. Conversely, in-the-money speeds were substantially faster on the GRADE shelf than others, primarily driven by generally faster speeds on HELOC collateral as the GRADE deals are often collateralized by a mix of CES and HELOCs (Exhibit 2).
Exhibit 2: Prepayment S-curves across shelves
Source: Santander US Capital Markets, CoreLogic LP
Looking at the attributes of prepaid loans shows those that do prepay tend to do so quickly, generally only having seasoned six to nine months on average. Average seasoning on prepaid loans in the GRADE program is roughly double that of the others analyzed but that is primarily driven by the presence of more seasoned observations in the GRADE program which began securitizing second liens well before the others. And while it may be that both nominal rate incentive and home price appreciation may drive prepayments in second liens given a relatively steep LLPA curve, deleveraging appears to have had limited impact on borrowers’ decision to refinance these loans as in most cases original and current LTVs were roughly in-line when the borrower prepaid (Exhibit 3). While completely anecdotal, the presence of prepayments absent meaningful incentive may suggest that some second liens are being used by borrowers as bridge loans where the proceeds are being used as equity for another home and the second lien is extinguished via prepayment once the initial property is sold.
Exhibit 3: Prepaid versus outstanding by shelf
Source: Santander US Capital Markets, CoreLogic LP
Looking across the largest collateral contributors to CES transactions, namely PennyMac, Rocket and SpringEQ shows loans originated by PennyMac have prepaid slower than those of Rocket and SpringEQ both at and in-the-money. All originators analyzed are paying almost on top of pricing conventions at the money, between 14 and 16 CPR. In-the-money speeds decouple to some degree across these originators. Given 100 bp of SATO-adjusted incentive, loans originated by PennyMac pay roughly 6 CPR slower than those originated by Rocket or SpringEQ and given 125 bps of incentive, the basis between PennyMac and Rocket loans widens to 7 CPR, prepaying at 17 and 24 CPR respectively.
Exhibit 4: Prepayment S-curves by originator
Source: Santander US Capital Markets, CoreLogic LP
Finally, investors weighing call probability when comparing structured cash flows to investment grade corporates should gravitate towards deals backed by closed-end second (CES) liens given the greater probability of calls being exercised in those transactions relative to non-QM deals. Increased likelihood of CES transactions being called is driven by the sizable differences in the price of loans backing CES deals versus those backing NQM trusts. The average price of collateral being contributed to non-QM trusts is roughly $102 to $103, meaning absent a sponsor hedging the call, collateral valuations can dip below the par call strike even without a major move upward in rates. By comparison, collateral backing CES deals generally ranges between $106 and $107, with the same par strike as NQM trusts. Given this, investors looking for short, soft bullet-like corporate surrogates may favor CES ‘AAA’ even over those of NQM exposures as they currently offer an additional 20 to 25 bp in nominal spread and substantially better prospects of being called.
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