By the Numbers
Non-QM deals likely to be called despite higher rates
This material is a Marketing Communication and does not constitute Independent Investment Research.
Higher benchmark rates have prompted some investors to question whether extension risk is rising. Slower prepayments are part of that concern, but investors are more focused on whether sponsors retain enough economic incentive to call eligible transactions. Many deals still appear to be in-the-money, suggesting call activity could remain elevated.
Recent call activity
Since the beginning of last year, sponsors of non-QM securitizations have called roughly $15 billion of collateral, split about evenly between last year and the first eight months of this year (Exhibit 1). More than half came from 2022-vintage transactions, with more than $8 billion of loans securitized that year having been called (Exhibit 2). Calls of 2022-vintage deals offer insight into the factors sponsors weigh when deciding whether to exercise a call.
Exhibits 1 and 2: Tracking recent non-QM call activity
Source: Santander US Capital Markets, Intex
Conventional wisdom holds that a call should be exercised when the collateral price is above the option’s par strike price. But sponsors consider several other factors. The 2022 vintage was marked by unfavorable securitization economics as rising rates and widening credit spreads increased issuers’ liability costs, reducing excess spread and the leverage sponsors could achieve through debt issuance. Despite wide variation in asset coupons among loans securitized in 2022, issuers are calling these deals. That suggests the liability side of a transaction can have greater influence on a sponsor’s call decision than the value of the assets.
Additional evidence that liabilities can matter more than assets in valuing the call comes from comparing the weighted average coupon, or WAC, on called transactions with an estimated primary non-QM origination rate at the time of the call. The estimated non-QM primary rate is the FHFA Primary Mortgage Market Survey rate plus 100 basis points, roughly consistent with the average spread at origination, or SATO, on loans securitized in non-QM trusts during the observation period. The comparison shows that many deals were out of the money when called (Exhibit 3).
Exhibit 3: Estimating moneyness at time of call
Source: Santander US Capital Markets, Intex, Bloomberg LP
Hedging offers one explanation. At issuance, sponsors can hedge the future value of the asset, potentially with payer swaptions, which give the buyer the option to enter an interest-rate swap at a specified future date at a rate set when the option is priced. For example, if a sponsor estimates the tail, or remaining duration of the collateral at the first call date, at two years, it could enter a three-year/two-year payer swaption. If rates at the call date are above the strike on the swap’s fixed-rate leg, the swap can be in the money even when the collateral is out of the money.
Callability of the outstanding universe
Future callability also reflects the roughly bimodal nature of the outstanding deal universe. Because front-end interest rates reached historic lows in 2020 and 2021, those vintages are likely to remain out of the money for the life of the transactions. Some higher-WAC deals could still be called after senior pro rata tranches are fully paid down and the remaining debt stack carries a net WAC coupon. As a result, the currently callable universe is largely made up of deals issued from 2022 through the first half of 2023.
Based on current benchmark yields and non-QM spreads across the capital structure, the weighted average cost of funds for a non-QM securitization is about 6.15%. The figure can vary by deal and issuer, particularly because of differences in credit enhancement for lower-cost debt at the top of the capital structure. Using 6.15% as a benchmark for current securitizations, call incentive can be estimated as the difference between an outstanding deal’s weighted average debt cost and the prevailing cost of funds.
Mapping that incentive against the next call date shows that many currently callable deals retain an incentive to be called despite the recent increase in benchmark rates (Exhibit 4).
Exhibit 4: Mapping call incentive from the liability side of non-QM trusts
Source: Santander US Capital Markets, Intex.
Note: Debt yield for outstanding trusts is calculated as the weighted average coupon of remaining outstanding debt, with no original-issue discount concession for first-loss classes.
The analysis shows that most deals callable over the next year, excluding the 2021 vintage, remain in the money on the liability side. Meaningfully negative call incentives do not emerge until the second half of next year. Even then, an important caveat applies: Deals callable in 2027 and beyond carry step-up coupons on the pro rata portion of the debt stack, covering the AAA through A rated classes.
Because advance rates to single-A classes have generally increased in recent issuance years, much of the outstanding debt will be subject to a coupon step-up four years after issuance. Nearly all trusts are projected to have less than 1 point of negative incentive before that adjustment, which could move call incentives from negative to positive after the step-up is taken into account.
The shape of the yield curve and implied forward benchmark and mortgage rates also matter. If the current curve persists, it suggests that many of these deals could be called because the forward benchmark rates used to price non-QM debt are not materially higher than spot rates.
Investors also consider the type of sponsor. Some have argued that fund sponsors are more likely to call deals than permanent-capital vehicles because funds generally must return capital to limited partners within a defined time horizon. Recent activity is mixed: Invictus has been the most active sponsor, accounting for roughly one-third of called balances, while Annaly Capital Management, a permanent-capital real estate investment trust, ranks second. Calls by both fund sponsors and permanent-capital vehicles suggest that the duration of a sponsor’s equity is not, by itself, a clear predictor of call behavior.
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