By the Numbers
Gauging relative value in short duration private MBS
This material is a Marketing Communication and does not constitute Independent Investment Research.
With non-QM ‘AAA’ MBS following agency MBS tighter and a growing set of other choices available in short-duration private MBS, investors should consider allocating some investable dollars outside of non-QM. Front sequential classes backed by agency-eligible investor loans and ‘AAA’ classes of securitizations backed by second liens look to offer attractive alternatives to certain non-QM exposures.
On the back of the administration’s announcement that Fannie Mae and Freddie Mac would increase their investment portfolios by as much as $200 billion, spreads on current coupon agency MBS tightened by roughly 20 bp. ‘AAA’ classes of non-QM securitizations initially lagged the tightening in the agency benchmark but have since captured the overwhelming majority, if not all of the move. ‘AAA’ spreads started the year around 125 bp to 130 bp but are currently hovering around 105 to 110 bp.
Given this, investors are likely evaluating other options to fill their short duration, out-of-index needs. And the menu of options is more substantial than in years past. The callable, modified pro-rata structure, common to non-QM, is now being used in securitizations of both second liens and, to a lesser degree, agency-eligible investor loans. And sequential classes of traditional shifting interest structures can be backed by TBA-like conforming, agency-eligible investor and jumbo loans. While absolute nominal spread matters, relative convexity across these cohorts, and how that convexity is levered through structure likely provides the best arbiter of relative value.
A look at convexity across private label
The simplest way to value convexity across a wide variety of private label cohorts is comparing the shapes of prepayment S-curves across the different exposures. The flatter the S-curve, the better the convexity as prepayment rates will remain more stable regardless of whether the loans backing the trust are in- or out-of-the-money. Based on this metric, three collateral cohorts stand out as exhibiting appreciably flatter S-curves than others, namely non-QM investor loans, agency-eligible investor loans and second liens. Out-of-the-money speeds on all cohorts can be propped up by home price appreciation as deleveraging creates incentives for investors to refinance the loan to extract equity and for second lien borrowers to refinance as the combined LTV on their loan declines and risk-based pricing spreads tighten.
Conversely, in-the-money speeds on these cohorts can be suppressed by a number of different drivers. Non-QM investor loans may pay slow in-the-money if costs associated with prepayment penalties outstrip trapped equity. Agency-eligible investor loans, which do not carry prepayment penalties, generally show a lagged response to refinancing incentive as originators will generally reach for easier to refinance owner-occupied loans first when rates fall and the refinancing index rises. And smaller second lien loan sizes can make fixed costs associated with refinancing those loans a more meaningful friction to refinance In contrast, non-QM owner-occupied loans, prime conforming and jumbo loans all have appreciably steeper S-curves (Exhibit 1).
Exhibit 1: Prepayment S-curves by PLS cohort
Source: Santander US Capital Markets, CoreLogic Loan Performance
Thoughts on relative value
While non-QM has followed the spread tightening in agency benchmarks, that does not preclude them from tightening further. Non-QM nominal spreads currently sit at roughly a 15 bp concession to current coupon agency MBS. Given substantially better convexity, non-QM ‘AAA’s should continue to look attractive on an option-adjusted basis versus current coupon pass-throughs. And that convexity and option cost advantage is going to be even more magnified in non-QM investor deals. Furthermore, many large investors value the relative liquidity afforded in non-QM relative to other private label exposures and the market looks likely to remain well supported.
Exhibit 2: Spreads and average lives of short duration private label exposures
Source: Santander US Capital Markets, CreditFlow
Front sequentials backed by both conforming owner-occupied and investor collateral compare favorably to conventional front sequential CMOs. 5.0% coupon CMOs backed by conventional 5.0% collateral are currently offered in the context of 90 to 95 bp. With spreads ranging from 115 to 125 bp for private-label options backed by conforming loans with comparable gross WACs, these bonds offer a roughly 30 bp pickup in nominal spread versus agency CMOs.
One wrinkle in short duration ‘AAA’s backed by agency eligible investor collateral is the use of a non-QM structure to securitize these loans as opposed to a traditional shifting interest one. And the basis between two structures currently sits at 20 bp. The introduction of the issuer call into the structure certainly offsets some of the convexity advantage of the investor collateral. Conversely, attractive pay up convexity in investor 5.5% should raise the likelihood of the sponsor exercising the call, as that pay-up increases substantially more if rates decrease than it falls if rates rise. However, that relationship is always subject to change, and given the substantial ambiguity associated with forecasting whether the sponsor will exercise the call, 20 bp may not be enough to forego the extension protection provided by the traditional sequential structure.
Finally, at a roughly 15 bp concession, the spread between ‘AAA’ classes of deals backed by second liens and non-QM looks likely to compress. Second lien collateral continues to deliver a consistently flat S-curve, albeit at faster speeds than most might have initially anticipated. At-the-money speeds on second liens appear poised to slow though, especially if annual HPA forecasts of roughly 3.5% projected by CoreLogic come to bear.
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