By the Numbers
Non-QM seniors, CRT deliver quality returns in private 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.
Investors at the recent ABS East conference by and large remained upbeat on residential credit, likely with good reason. Certain areas of mortgage credit, namely non-QM seniors and CRT mezzanine and subordinate classes have delivered attractive risk-adjusted returns in the last year, beating those of MBS, investment grade and high yield credit by fairly wide margins.
An analysis of various mortgage credit exposures shows that over the past year, non-QM seniors and mezzanine and subordinate classes of Fannie Mae and Freddie Mac credit risk transfers have delivered the highest risk-adjusted returns beating those posted by bonds across the capital structure in both prime jumbo and seasoned RPLs. The 1-year Sharpe ratio posted by non-QM seniors was substantially better than those of both the aggregate MBS and investment grade corporate bond indices. Mezzanine classes of CRT significantly outperformed the investment grade index as well. While subordinate classes of GSE CRT bonds fared markedly better than the high yield index.
Comparing returns at the top of the capital structure
Despite multi-year low levels of rate volatility, longer duration MBS and corporate indices have struggled to offer substantial returns over the past year when measured on either a nominal or risk-adjusted basis. Over the past 12 months the MBS index has posted an average monthly return of just 28 bp while the broad investment grade index has returned just 32 bp. All RMBS exposures at the top of the capital structure analyzed have delivered better nominal returns than both MBS and investment grade corporates. A cohort comprised of a comprehensive float of ‘AAA’ classes of non-QM securitizations offered an average monthly return of 48 bp while senior classes of deals backed by seasoned re-performing loans and prime collateral returned 40 bp and 37 bp respectively (Figure 1).
Exhibit 1: Senior non-agency RMBS offer better returns than MBS and IG corporates
Source: Santander US Capital Markets, YieldBook MBS & Broad Investment Grade (BIG) Indices
When analyzing returns on a volatility-adjusted basis, the advantage offered by private label RMBS exposures is more pronounced. Non-QM seniors have delivered a 1-year Sharpe ratio of 0.77, 59 bp better than the Sharpe ratio posted by the MBS index and 54 bp better than that of that of the investment grade corporate index (Exhibit 2).
Exhibit 2: Non-QM seniors deliver attractive risk-adjusted returns
Source: Santander US Capital Markets, YieldBook MBS & Broad Investment Grade (BIG) Indices
Non-QM ‘AAA’s have likely outperformed both MBS and corporates for a couple of reasons. Firstly, despite recently depressed observations, rate volatility did spike in both November of last year and in April, fueled by the market’s reaction to tariffs imposed on Liberation Day. As a result, shorter-duration non-QM ‘AAA’s were able to outperform on a relative basis against the backdrop of heightened rate volatility. With that said, the difference in duration between non-QM ‘AAA’s and MBS and corporate indices is not as pronounced as it has been in the past as much of the outstanding cohort is comprised of lower coupon bonds backed by slow paying, low WAC collateral that are unlikely to be called.
Secondly, and somewhat counterintuitively, non-QM spreads may have a firmer backstop than agency MBS and investment grade corporate spreads given the current structure of the private label market. Unlike in the past, when the overwhelming majority of non-conforming loans were earmarked for securitization, a large swath of non-conforming origination is now funded via a combination of Federal Home Loan Bank advances and annuity issuance by life insurance companies. This stickier and more stable form of financing has proven to be somewhat of a governor to how much loan spreads can widen into bouts of spread volatility as large insurance buyers have continued to fund whole loan purchases, effectively capping implied ‘AAA’ execution.
GSE CRT still offers attractive risk-adjusted returns but prospects may be weakening
Uncapped, floating-rate structured product exposures such as CLOs and GSE CRT have consistently delivered attractive risk-adjusted returns to investors. One-year Sharpe ratios posted by both CRT mezzanine and subordinate bonds both doubled the volatility-adjusted return posted by the high yield index. CRT subordinate and mezzanine bonds delivered Sharpe ratios of 1.36 and 1.31 respectively with the high yield index posting a return of just 64 bp. While GSE CRT bonds continue to offer attractive risk-adjusted returns, they have been capped to some degree as the enterprises have introduced shorter-dated par call options which have limited potential price appreciation. Furthermore, the enterprises have limited or in some cases discontinued issuing longer spread duration, deeper subordinate bonds, further limiting potential price appreciation into a rally in credit spreads (Exhibit 3).
Exhibit 3: Stacking up risk adjusted returns across mezzanine and subordinate RMBS
Source: Santander US Capital Markets, YieldBook MBS & Broad Investment Grade (BIG) Indices
Over the past year, subordinate classes of non-QM deals have offered the highest Sharpe ratio across all other residential credit exposures. Returns across deeper subordinate classes of non-QM deals have been fueled, to some degree, by an uptick in call activity by sponsors, pulling deeply discounted non-investment grade classes of these deals to par. Investors in these classes may continue to benefit from this price appreciation as more 2022 and 2023 vintage deals become callable.
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