By the Numbers
Non-QM ‘AAA’s should help buffer volatility
This material is a Marketing Communication and does not constitute Independent Investment Research.
Uncertainty around the impact of war in the Middle East has left some investors looking for more defensive positions to weather rising volatility. Non-QM ‘AAA’s fit that bill with both limited interest rate and spread duration and good carry and convexity. They have also provided strong risk-adjusted returns compared to other private MBS and agency MBS pass-throughs.
Investors are wrestling with a potential new set of market outcomes. Although credit spreads have broadly stayed close to levels before war broke out, fixed income spread products are vulnerable if the conflict in Iran becomes protracted. Uncertainty and a growing range of possible outcomes would likely continue to put upward pressure on interest rate volatility and on agency MBS spreads as option cost increases. With volatility on the rise and MBS spreads vulnerable, investors should consider more defensive positions across the spectrum of structured products to ride out the bout of volatility.
The case for relative value in non-QM ‘AAA’s
Top tier non-QM ‘AAA’s have widened by roughly 25 bp compared to recent tights, primarily driven by spread widening in the agency MBS basis which has retraced to levels last observed in January, prior to the administration’s announcement that the GSEs would be purchasing $200 billion in agency MBS. The spread to the interpolated Treasury curve on current coupon MBS pass-through throughs currently sits at 110 bp, with top-tier non-QM ‘AAA’s pricing at 125 bp to 130 bp over Treasuries at new issue. Over a 2-year observation, non-QM ‘AAA’ spreads have averaged 129 bp with current coupon agency spreads averaging 135 bp. At a roughly 20 bp concession to agency MBS, non-QM ‘AAA’s are the widest they have been to agencies in nearly a year. The only other time over the past two years that non-QM ‘AAA’s offered such a meaningful concession to agency MBS was in April of last year in the wake of Liberation Day tariff announcements (Exhibit 1). And within a month, the spread between the two narrowed to just 5 bp.
Exhibit 1: Non-QM ‘AAA’s offer the biggest concession to agency MBS since Liberation Day
Source: Santander US Capital Markets, Bloomberg LP
Non-QM may be poised to outperform agency MBS for additional reasons too. Recent military actions and potential inflationary implications have driven a font-end bear steepening of the yield curve as the probability of Fed cuts this year has become increasingly remote. The rise in the front-end benchmark rates has improved carry in non-QM ‘AAA’s given both their pricing WAL and the majority of their key-rate duration sits on the 2-year part of the curve. Furthermore, with overall negative convexity and prepayment speeds expected to increase in agency MBS, more convex non-QM loans should offer a more stable return profile.
Stacking up risk-adjusted returns
Looking across the spectrum of private MBS exposures, certain cohorts do deliver better risk-adjusted returns over a 1-year horizon than non-QM seniors, namely CRT mezzanine bonds and bonds across the capital structure in deals collateralized by second liens (Exhibit 2). With that caveat, there are still reasons investors may favor non-QM ‘AAA’s over those bonds. New issue CRT mezzanine bonds already trade at very tight nominal spreads and have shown limited capacity to tighten significantly from their primary trading levels. And for levered accounts, they do not finance efficiently. Second lien seniors are an attractive proxy for non-QM ‘AAA’s in terms of both cash flow and collateral convexity. However, they are significantly less liquid than top tier non-QM seniors. And given price tiering observed across recently issued non-QM deals, investors are putting a growing premium on bonds the market perceives to be more liquid against the backdrop of steadily increasing volatility. Bonds further down the capital structure in second liens are likely exhibiting relatively elevated risk-adjusted returns given a dearth of trading and lack of frequent pricing observations.
Exhibit 2: Risk-adjusted returns across MBS exposures
Source: Santander US Capital Markets, CoreLogic Loan Performance, Intex, IDC
Comparing the cohort to agency MBS, non-QM seniors offer a significantly better Sharpe ratio than both 30-year UMBS and Ginnie Mae MBS. Non-QM seniors offer a 1-year Sharpe of 1.67 with UMBS and Ginnie Mae 30-year MBS offering Sharpes of 0.71 and 0.68 respectively. 15-year UMBS MBS, which somewhat of a better duration comparison to non-QM, delivers a Sharpe ratio of 0.97.
One interesting additional layer of analysis is to further cut the non-QM ‘AAA’ cohort by vintage. This allows us to stratify the universe into lower gross WAC, Covid-era transactions, which are longer duration, to more recently issued, higher WAC pools. When cutting the universe, the 2021 and 2022 vintage stand out as offering the highest average monthly returns, likely driven by prepays pulling to par on deeply discounted bonds. The 2023 vintage stands out as offering the best risk-adjusted return by far (Exhibit 3).
Exhibit 3: 2023 and 2024 vintage non-QM ‘AAA’s offer the best risk-adjusted returns
Source: Santander US Capital Markets, CoreLogic Loan Performance, Intex, IDC
The substantially better risk-adjusted return in the 2023 vintage looks to be a function of the fact that, when looking at prepayment S-curves by vintage, the 2023 cohort stands out as having a fairly flat and stable S-curve, while prepayments in other vintages appear more volatile given differing levels of moneyness. Admittedly, some of the volatility in other vintages looks to be a function of small samples of loans deep in-the-money but when viewed in totality, the 2023 vintage looks to be the most convex of recently issued non-QM. (Exhibit 4) With that said, the 2023 vintage is also flashing as somewhat credit impaired relative to other cohorts and investors need to be mindful of both the absolute level and trajectory of delinquencies when selecting 2023 vintage AAAs.
Exhibit 4: 2023 vintage non-QM deals appear to offer better convexity than other cohorts
Source: Santander US Capital Markets, CoreLogic Loan Performance
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