Non-Agency RMBS – Mike Hsu

Despite COVID cases escalating, investors seemed solely focused on vaccine developments and the accelerated economic rebound they signal – with risk assets remaining well supported into year-end.

Non-Agency RMBS was no exception, as spreads continued tightening during the month, making significant headway in retracing March’s widening. As an example, longer duration legacy passthroughs rallied another 10-20 basis points in December and ended the month around swaps +180-200 basis points (bps), as compared to pre-pandemic tights of +110bps and March wides of over +1000bps.

Credit compression remained the dominant theme throughout the fourth quarter, with subordinate bonds outperforming. Active new issue pricing in 2.0 RMBS sectors, such as credit risk transfer (CRT) and Non-Qualified Mortgages (non-QM), illustrated some of this credit compression.

For example, Freddie Mac issued four post-COVID CRT deals from its low loan-to-value (LTV) collateral (DNA shelf). In the chart below, the basis between the BBB-rated M1s and unrated B2s narrowed from +785bps in June to +475bps in December.

CRT

While the non-QM credit curve didn’t compress as much as CRT, largely due to lingering concerns around performance given it’s a less mature and rather untested sector, you can still see the progressive tightening in new issue deals from Angel Oak’s shelf (AOMT); the issuer priced six transactions since March. Spreads on Angel Oak’s December issuance (AOMT 2020-R1) resembled early 2020 (pre-COVID) levels.

Non–QM

With outperformance down the capital stack, sellers emerged to lock in gains, extending the rotation out of fast money accounts and into the real money community. Demand remained buoyed by real money’s search for yield and the continued strength of housing. Secondary bid list volume totaled $3.3 billion in December, with particularly elevated supply in CRT bonds ($727 million).

CMBS – Sagar Parikh

December saw record secondary supply of Investment Grade (IG) conduit CMBS, driven by strong demand for previously avoided “COVID-sensitive” sectors, such as retail and hospitality. Conduit AAs and single-As ended the month +50-100bps tighter. For desk activity highlights, we bought MGM Grand and Mandalay Bay CMBS in primary, as a high quality credit with some hospitality spread pick-up (BX 2020-VIV4 A; priced swaps+160, trading very low 100s), and added AAA CRE CLOs in secondary, as spreads lagged other CMBS (buying AAAs in the M100s dm, now trading low 100s dm).

As for fundamentals, lenders and CMBS controlling class certificate-holders seem more sympathetic than during the global financial crisis (GFC), at least thus far, with significant temporary relief from forbearance agreements and increasing permanent relief from modifications and extensions. However, it’s still early days for loan resolutions; CMBS delinquencies and special servicing rates remain elevated though only 25% of specially serviced properties have received updated appraisals and liquidations remain low.

The trend of high forbearance and modification activity and limited distressed sales extends beyond CMBS into broader CRE. Distressed, sales represent only 1% of total transaction volume currently, despite around $130BN of distressed and potential-distressed assets, according to Real Capital Analytics. For historical context, post-global financial crisis (GFC), distressed sales as a percentage of total sales peaked at 21% in 2010.

Importantly, these data points remind us that we’re still early days in the workout leg of CRE’s “K-shaped” recovery. Lagging indicators like the Commercial Property Price Index (CPPI) signal price appreciation on the year (+5.7% YoY through November), driven by outperforming market segments and stronger-asset transactions benefiting from some incremental capitalization rate compression. We’d caution that more timely indicators should not be ignored, such as the severe drop in overall transaction volume (down 40% through November), significant decline in net operating income (NOI – down 7.2% 3Q.20, NCREIF and MS), and tighter lending standards.

The “K” Recovery in CRE Prices

Source: Credit Suisse and Real Capital Analytics

Distress Sales Activity Remains Low

Source: Real Capital Analytics, Morgan Stanley Research

Distress Sales as % of Total volumes Peaked When the CPPI Bottomed in 2010

Source: Real Capital Analytics, Morgan Stanley Research

ABS – Tony Lee

In ABS, light supply in both primary and secondary exacerbated fourth quarter technicals and spread compression continued as dealer inventories approached their 2020 lows. New issue totaled $3.3BN in December, bringing full-year supply to $175BN, over $50bn lower than full-year 2019 ($228bn).

Senior high quality consumer ABS spreads remain anchored around one-year tights and subordinate and specialized ABS sectors – like FFELP student loan subordinates, subprime auto subordinates and rental car ABS – took meaningful steps tighter in December. Senior Avis sponsored rental car ABS tightened over +25bps, from +125bps to inside +100bps, for four year bonds.

Despite an initial spike in unemployment, consumer credit performance held up well in 2020, supported by fiscal and monetary stimulus in addition to lender payment relief programs. Auto loan modification and payment relief requests spiked in the first and second quarters then came down just as fast. As one would expect, subprime auto loan borrowers requested and utilized lender relief at the highest rate, reaching a peak of ~16% in April, while prime borrowers used relief at a significantly lower rate. (Exhibit below)

Consumer unsecured loan ABS also outperformed credit expectations in 2020, especially the previously untested marketplace segment (peer-to-peer). Marketplace loan delinquencies peaked around 3.5% from late 2016 through early 2017. In contrast, COVID relief measures helped lower delinquencies to a little over 2% in 2020. Marketplace consumer net losses similarly peaked in late 2016, at around 12%, and currently hover around 5.5%. Focusing on 2020, COVID relief ultimately translated into improved delinquencies and losses in consumer unsecured, for both marketplace and traditional branch-based lending.

Auto Loan ABS Modification by FICO

Source: BOA Research, Related transaction SEC filings

Consumer Loan ABS 30+ Day Delq

Source: BOA Research, Intex

Consumer Loan ABS Net Losses

Source: BOA Research, Intex

CLO – Palak Pathak

Secondary

Secondary activity was heavy at $12.1 billion, including an 11% increase in investment grade (IG) secondary supply month-over- month. Overall 2020 CLO trading volume increased an astonishing 60% over 2019 flows, with over $160 billion in total trading volume.

Reviewing spreads during the month, CLO AAAs tightened slightly while the term curve steepened, with shorter term paper moving inside of 100bps discount margin (dm) and longer duration paper trading high-120s dm. Higher investment grade mezzanine debt also tightened, with AAs and single As 5-10 bps tighter, ending the month in the 150s dm and low 200s dm, respectively. Tightening remains capped by callability, as investors remain sensitive to premiums.

Further down the capital stack, the demand for risk and convexity was on full display in BBBs and BBs as underlying loan prices continued to increase. CLO BBBs and BBs spreads ended the month 20-50bps tighter, with tier 1 BBBs tightening into the low 300s and Tier 1 BBs to 600dm.

In CLO equity, median Net Asset Values (NAVs) increased 12 points during December, to $45. Total cash-on-cash returns for CLO equity averaged 11% for 2020.

Secondary CLO 2.0 Spreads (dm)

Source: TCW

Primary

Primary issuance was robust in December with $10.4 billion pricing across 25 deals – one of the busiest Decembers in CLO primary since 2012. Total 2020 gross issuance was around $90 billion, down 24% year-over-year, with net issuance closer to $60 billion.

As for spreads, primary was flat to slightly tighter for investment grade (IG) debt while BBs were 15bps tighter. Tier 1 AAAs priced at +120bps and low to mid-130s for 3-year and 5-year reinvestment periods, respectively. The AAA term curve steepened with short refinancings pricing at 100dm, compared to 3-year and 5-year reinvestment deals pricing at 120dm and 135dm, respectively. In mezzanine debt, AAs and single-As remained flat while BBBs tightened 5 bps. BBs tightened the most as loan prices continued to rally with most Tier 1 BB prints inside 700dm. The cost of debt declined only slightly, by 2bps, as AAAs, the largest contributor to CLO Weighted Average Cost of Capital (WACC), remained flat.

For middle market CLOs, three new issues priced during the month, with AAA spreads stable in the 180-190dm range.

CLO New Issuance

Source TCW

Tier 1 New Issue Spreads

Desk Activity

We found better value in the primary market in December, especially at the top of the stack, buying longer duration primary AAAs and AAs +10-15 bps wide of secondary levels. Unless primary tightens further or secondary widens (relieving some near-par/par pressure), we’ll continue to prefer primary AAAs and AAs, picking up with 1-2 years of call protection, better credit enhancement and cleaner collateral.

Fundamentals

CLO tail risk continued to decline as (1) CCC buckets decreased, either through upgrades, prepays or manager sales and (2) loan prices increased, reducing the percentage of loans <$80 by 1% to 3.7%.

Median CCC exposure is currently 8% and if the trend continues CCCs should cross the 7.5% threshold, which would boost junior overcollateralization (OC) cushions in many deals. The reduction in CCC-rated assets decreased weighted average rating factor (WARF) levels by 30 pts and the increase in loan prices lifted BB MVOCs by another percentage point to 105%, closely approaching Jan 2020 levels of 106%. We expect continued mezzanine demand and the potential for positive rating actions if this fundamental improvement continues.

Total Return

The positive CLO performance from November continued into December, with CLOs returning 0.71% over the month. All tranches had positive returns largely, driven by price appreciation. Similar to the credit compression in other securitized sectors, the bottom of the capital structure had the best returns, with single-Bs returning 9.15% over the month (their best monthly return since June).

For the year, CLOs returned 3.11%, below their 2019 annual returns of 5.5%, but still a remarkable feat given the -8.63% return realized in March. Comparing CLO annual performance to Investment Grade credit (IG), High Yield credit (HY) and Leveraged Loans, CLOs underperformed IG (+9.35%) and HY (+7.11%) and were flat to Leveraged Loans (+3.12%). Reviewing specific classes, CLO BBs experienced the best absolute performance at 8.04% return – outperforming HY and Leveraged Loans, on an annual basis.