By the Numbers
Non-QM seniors, CRT offer best risk-adjusted returns
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.
With equity and rate volatility high, investors in residential credit may be re-evaluating their exposures based on which have delivered elevated and steady returns. Investors at the top of the capital structure should continue to reach for ‘AAA’ classes of non-QM deals, while credit investors should look to overweight CRT and seasoned non-QM versus other exposures.
Volatility increases on tariff uncertainty
Investors across markets have seen precipitous increases in both equity and rate volatility over the last month as the administration has changed tack on timing, scope and magnitude of tariffs levied across international trade partners. Equity volatility, as measured by the VIX index, has risen more than 50% since the middle of February while rate volatility, measured by the MOVE index has increased by roughly 25% (Exhibit 1).
Recent comments by Commerce Secretary Howard Lutnick suggest that a more consistent and clearly articulated tariff policy may be forthcoming, which should, in turn, dampen recent spikes in volatility. However, investors across markets may look to re-position portfolios to reduce both rate and spread duration while rotating into exposures that carry less exposure to levies against imports. These factors, in confluence, should support shorter duration, consumer-based assets compared to longer duration corporate exposures.
Exhibit 1: Equity and rate volatility higher on tariff uncertainty
Source: Santander US Capital Markets, Bloomberg LP
Non-QM ‘AAA’s post the highest Sharpe ratio across senior exposures
Through the last three years, which include both a protracted rise in interest rates and substantial rate volatility, the universe of non-QM ‘AAA’ cash flows offered the highest return per unit of risk, measured as the volatility of monthly return. Non-QM ‘AAA’s have delivered a three-year Sharpe ratio of 1.13, substantially greater than the 0.84 posted by legacy prime seniors which offered the second-best risk adjusted return amongst senior exposures. ‘AAA’ bonds backed by prime jumbo and investor collateral have provided the worst risk-adjusted returns over the observation period at 0.45 (Exhibit 2).
Elevated risk-adjusted returns in non-QM seniors are in no small part a function of these cash flows being shorter duration than other exposures despite certain vintages remaining substantially out-of-the money relative to the par call on the structures.
Recent price action has reflected investor bias towards shorter duration, more positively convex non-QM cash flows over prime jumbo pass throughs and sequentials. Non-QM ‘AAA’s have widened by roughly 10 bps versus recent tights, with Tier 1 issuers pricing at 135 bp over interpolated Treasuries. In contrast, 6.0% coupon prime pass throughs have widened by roughly twice as much as non-QM seniors. Pass throughs classes of jumbo deals have widened 0.75 points from roughly 20/32s back of TBA to $1-12/32s back, or a spread widening of roughly 20 bp.
Within non-QM ‘AAA’s, pools backed by higher concentrations of investor collateral should outperform pools weighted towards owner-occupied loans. Pools stocked with larger concentrations of investor loans should offer better convexity given the presence of prepayment penalties on these loans. Furthermore, pools with larger concentrations of investor loans will carry greater amounts of credit enhancement through the pro-rata stack, keeping these bonds structurally shorter than comparable bonds backed by larger concentrations of owner-occupied loans as investor heavy deals will often carry an additional ten points of enhancement to the single ‘A’ enhancement level, below which the structure pays sequentially. And while this greater enhancement will make the pro-rata structure more levered to prepayments, this is largely offset via optimizing the structure to solve for a par coupon at issuance.
Exhibit 2: Sharpe ratios by collateral cohort and capital structure
Source: Santander US Capital Markets, CoreLogic LP, Intex Solutions
CRT best across mezzanine and subordinate exposures
Increased levels of rate volatility could spur additional investment in GSE CRT as the asset class has provided by far the best risk adjusted return for mezzanine and subordinate investors over the past three years, although there are likely some caveats. While CRT has delivered the best Sharpe ratio for mortgage credit investors over the past three years, much of the carry in these bonds has been generated via the Federal Reserve’s aggressive tightening of benchmark rates. With market implied probabilities signaling three cuts through the rest of the year, carry and total return on these bonds appear poised to decline, potentially making them a less attractive option for investors down the stack.
Furthermore, issuance in recent years has skewed towards lower-cost, investment grade risk which provides the enterprises with comparable risk-based capital relief to higher cost, deeper subordinate risk under the Enterprise Regulatory Capital Framework (ERCF), limiting supply of higher carry, deeper credit exposure for investors. Away from CRT, legacy prime and Alt-A credits have offered the most attractive risk adjusted returns for mezzanine and subordinate investors however levels of price volatility in legacy may be somewhat depressed given limited trading volume and price transparency in these exposures. Ultimately, deeper credit investors who are looking to remain defensive may look to seasoned, higher WAC non-QM mezzanine and subordinate bonds for higher carry, short duration exposure to residential credit as seasoning will shorten spread duration and higher WAC pools that are in-the-money versus the par call will trade to short empirical durations.
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