Amid a credit environment already altered by historically low interest rates, jitters about whether inflation will abruptly raise low rates, and a strong housing market, non-QM issuers are tapping into the refinancing wave, and driving a wave of early redemptions on securitized deals.
In June 2020 non-QM deals numbered 103, with $27 billion in outstanding balances, and 38 of the deals exercised early redemption options, according to Deutsche Bank research. By June 2020, non-QM deal balances from last year had been down by 52% last year through amortizations, prepays and exercised deal redemption options, Deutsche Bank research found, and the average redeemed deal had 47% of their original balances outstanding.
"The higher prepayments have really been driven by lower interest rates and, to some degree, borrowers’ anxiety over rising rates as well,” said Simon Mui, a research analyst at Deutsche Bank. In the last five years, home prices have increased more than 40%. Prepays are occurring among securitizations that are seasoned for one year or more.
There are a lot of early prepayments among conventional loans, but the strong housing market is also benefiting non-QM loans because those deals tend to have borrowers who may be a little more willing to take advantage of the home equity in their properties, Mui said.
Analysts agree that low interest rates are rendering non-QM deals eligible for calls, and driving activity in the non-QM space in recent weeks. Most non-QM deals are eligible to be called at the earlier of three years from the closing date or when the pool has paid down 70%, said Sujoy Saha, a director at S&P Global Ratings RMBS team.
Most redeemed deals from June 2020 were within three months of their call dates, according to Deutsche.
“Many of these transactions that we are seeing being called are from 2018 or earlier,” he said, when interest rates were higher. Bonds from the 2018 vintages were issued with higher interest rates, in turn. Issuers can now place notes at lower interest rates backed by the same collateral, so they can lower their obligations to bondholders without having to assemble higher quality collateral pools.
“There’s an economic incentive there for issuers,” Saha said. “It also gives an indication that there is a market for these newly issued bonds, which are backed by this called collateral.”
Whether the prior bondholders could benefit when these post-call deals is still an open question. Some bondholders might have preferred the older transactions with relatively high coupons to continue on rather than having to re-deploy cash proceeds in the current market. Others might have been happier that the deals paid off and they got back their principal, Saha explained.
Cleaning up their act
Refinancing outstanding securitized debt is more than just about saving debt servicing costs. It is also an opportunity to cleanse the pool, which is what a lot of issuers do, Saha noted. Loans that experienced delinquencies, foreclosures, or forbearances may not be part of the re-securitization subsequent to the call, but become a part of another transaction instead, like a re-performing or non-performing loan transaction.
From the investors’ point of view, there has been an appetite for non-QM deals with the refinanced deal ending up being of higher credit quality. “The seasoned loan component in the non-agency RMBS has been reasonably healthy and the re-performing sector has been fairly healthy as well. When these deals are called and they pool loans from new deals, they pull out the cleaner loans for the new deals also. So the weaker performing loans may be called out and put into a warehouse line as opposed to going into securitizations,” Mui said.
The inflation factor
While the credit markets await Federal Reserve action on interest rates, borrowers are preempting central bank action in their bids to refinance. The anticipation of potential inflation and the expectation that inflation would lead to higher rates are driving the refinancings. “To the extent that there are borrowers who are looking at the possibility of higher inflation and, at the same time, their loans are “in the money” or have intrinsic value, this is going to lead to higher prepays," Mui said. He explained that after the financial sector started its recovery from the Financial Crisis of 2008, back offices automated much of the lending and underwriting processes, which increased the fluidity or speed in refinancings as well.
The U.S. has recently experienced the highest level of inflation seen for quite a while. In April, there was a 5% year-over-year increase in CPI, the highest since 2008. It is not clear how the CPI step up would directly impact the non-QM market, according to Tom Schopflocher, a senior director at S&P Global Ratings.
“If you have a fixed-rate debt obligation (which borrowers do when they take out a 30-year- mortgage), there’s an argument to be made that, assuming all prices go up (including wages), a borrower’s debt is decreasing over time in real terms,” Schopflocher said. Wages are generally not keeping up with inflation, however, making inflation a secondary driver of prepayments.
The downside of the paydowns is that deals are being priced fairly quickly, Mui said.
“When non-QM deals come to market, the general pricing speed is higher at a constant prepayment rate (CPR) of 20-25. This is a little faster than it was during the past few years — which was at a range of 15-25 CPR — depending on the deal. To the extent that inflation leads to higher rates and lower prepayments, there will be longer duration that can likely lead to wider spreads, which is a risk that the market faces in an inflation scenario,” Mui said.
Outlook for spreads
Current securitization spreads, in general, are tight and expected to widen slightly into yearend, Mui said. This is due to some of the outlier events in the market that may occur including the Delta COVID variant that might impact the macro side of the market again. There are also the market concerns over inflation and rates, he said.
To the extent that the risks of inflation increase and rates pick up more, the market may see spreads widen, Mui said. ABS issuers may have to increase yields to entice investors. In this scenario, non-QM slightly outperforms corporates in terms of yields offered.
"We think non-QM slightly outperforms corporates in general and that is due to supply- demand dynamics,” Mui stated.
