As we eagerly turn the calendar over to 2021, investors in non-agency residential mortgage-backed securities (RMBS) would be remiss to jump into the new year without keeping top of mind what transpired in 2020. While spreads across non-agency RMBS have retraced most or all of the widening that occurred during a volatile year, the state of this sector looks much different than at the start of 2020. Reperforming loan (RPL) securitizations outperformed other areas in non-agency RMBS due to longer duration profiles and slower prepayments. Entering 2021, a challenge for RPL will be a worsening convexity profile. Many of these bonds are trading at a significant premium, coupled with faster prepayment speeds resulting from a combination of credit curing in more seasoned deals and lower overall mortgage rates. While backed by the highest-quality loans, jumbo prime deals displayed very elevated prepayment speeds in 2020. Seasoned bonds that have been prepaying quickly have repriced to a very short cash flow. In new issue, deals are pricing the AAA 2.5% pass-through class at a high 103 dollar price, making the convexity profile for these bonds less appealing.
Non-qualified mortgage (non-QM) securitizations — deals backed by loans not eligible for purchase from Fannie Mae or Freddie Mac — feature some intriguing characteristics in which investors may find value as we start 2021. Non-QM was not immune to the elevated prepayment speeds seen in 2020; however, structural features in non-QM deals can offer additional call protection. Bonds in new issue non-QM are priced at par and bonds trading in the secondary market have been trading close to or at the earliest call date (most non-QM deals feature a call date anywhere from one-and-a-half to three years from issue). The deal waterfall can offer investors choices for duration profiles. Traditional non-QM deals are structured with a pro-rata senior structure (AAA through A classes, which flips to sequential if delinquency or loss triggers are hit) and sequential structure for the mezzanine and subordinate classes. A handful of 2020 non-QM deals were issued with a sequential senior structure.
Another feature of non-QM is the presence of excess spread generated by the deal structure. Excess spread exists in these deals because the weighted-average coupon (WAC) on the underlying mortgages is considerably higher than the cost of funds (the WAC paid on the bonds in the securitization). Each month after interest has been paid to the bonds, excess spread is used to pay any current or prior losses the deal has incurred. Any leftover cash flow is paid to an XS class retained by the issuer. Despite rising delinquencies in 2020, the excess spread has preserved cash flow to non-QM deals.
Key Takeaway
After shutting down at the start of the pandemic, the non-QM new issue market picked back up in the summer as market conditions became favorable for issuers to securitize their pre-pandemic originations. By the end of 2020, investor demand had driven the cost of funds for issuers to multi-year lows. As we look ahead to the rest of 2021, demand should remain strong for par-priced deals, generating several points of excess spread. Supply at the start of 2021 may be more heavily weighted toward resecuritizations of called deals rather than new originations, as the focus for originators has been on agency-eligible mortgages since the start of the pandemic.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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