By the Numbers
Gauging relative value across second lien and non-QM seniors
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.
When measured against nominal agency MBS spreads, valuations of short ‘AAA’ private-label MBS look stretched. However, current valuations are likely supported by the perception that these private-label MBS are significantly shorter in duration and more convex than current coupon MBS, making them more comparable to short duration corporates. If the market sees relative value in these features, then senior bonds backed by second lien collateral may tighten further and outperform non-QM ‘AAA’s.
Spreads across the top of the capital structure in residential credit remain tight, nominally in-line with current coupon MBS. Senior cash flows backed by both closed-end second liens and non-QM collateral currently trade to roughly 125 bp to 130 bp over Treasuries at their pricing speeds, on top of current coupon MBS. (Exhibit 1). Far superior liquidity afforded by the TBA market suggests that, all else equal, private label ‘AAA’s should always trade at a concession to agency MBS. Therefore, these bonds should only trade inside of MBS when they offer comparable return for lower risk, in the form of shorter duration, better convexity or some combination of the two. Shorter effective durations are driven by structure and callability of senior bonds while better convexity is driven by substantially lower loan balances than the current TBA deliverable. Greater certainty of short-dated calls being executed coupled with substantially lower loan sizes in deals backed by closed-end second lien collateral suggests that they should continue to outperform versus both non-QM and agency MBS benchmarks.
Exhibit 1: Private label seniors trade in line with current coupon MBS
Source: Santander US Capital Markets, Bloomberg LP
Thoughts on callability
Closed-end second lien and non-QM securitizations lend themselves to relatively straightforward relative value comparisons given similar structural features. Amongst other comparables, both structures feature a 3-year optional redemption and 4-year coupon step-up. While the coupon step-up creates substantial incentive for sponsors to call transactions as the combination of deleveraging and the step-up will increase a sponsor’s cost-of-funds and decrease their levered return, other factors will weigh on callability. The most meaningful driver of callability should, all else equal, be the level of moneyness of the collateral relative to the par strike to determine whether a sponsor chooses to exercise the call.
A view of future callability can be informed by the shape of the forward mortgage rate curve. While there is not a standardized forward mortgage rate for non-QM loans, a reasonable proxy can be created using the Primary Mortgage Market Survey (PMMS) forward rate plus some assumption for the credit spread over the prime rate (Exhibit 2).
Exhibit 2: Forward non-QM primary rates roughly in-line with current
Note: Rate is constructed assuming PMMS rate plus a spread of 137.5 bp, the weighted average Spread at Origination (SATO) for loans securitized in non-QM trusts over the course of 2024.
Source: Santander US Capital Markets, Bloomberg LP.
Based on the forward curve, primary non-QM rates may only be 20 bp to 25 bp lower than current $102 price rates. Based on the duration at the horizon, these loans may only be trading at a somewhat negligible premium to par when the deals become callable. This simplified analysis also assumes no additional spread widening or discount applied to loans that may be delinquent, defaulted or in REO at point of call which could further impair callability. Conversely, loans backing second-lien trusts trade to a substantially higher premium than non-QM, with ingoing collateral prices of $106 to $107. Greater moneyness in second lien collateral should translate to higher call probability and shorter spread and rate duration for senior bonds, likely giving them greater ability to tighten versus short corporate or ABS cash flows.
Valuing convexity
Better convexity in second-lien collateral relative to non-QM is primarily a function of loan balance. The overwhelming majority of securitized, fixed rate second liens carry balances less than $100,000 while the weighted average loan size of non-QM trusts hover around $450,000. And while certain non-QM cohorts, particularly investor loans with 5-year prepayment penalty structures do offer attractive call protection, smaller average loan sizes in second lien deals have, to date, translated to performance that mirrors conventional loan balance performance, with steady prepays and a flat S-curve on either side of par (Exhibit 3).
Exhibit 3: CES loans exhibit flatter S-curve than non-QM
Source: Santander US Capital Markets, CoreLogic LP
The flatter S-curve exhibited by CES collateral should translate to lower option cost and greater OAS for CES seniors. Additionally, faster out-of-the-money speeds should shorten both spread and rate duration on second liens relative to non-QM collateral in any ‘non-call’ scenario. Current tight valuations, rising rate volatility and growing uncertainty around the path of future rates across the curve may push investors into shorter, more defensive cash flows, suggesting second lien ‘AAA’s may outperform non-QM in the near term.
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