Unlocking potential: Opportunities in residential mortgage-backed securities

Low convexity trades in the residential sector

Interest-rate volatility has been one of the biggest pain points for fixed income investors over the past two years and may persist in 2025. However, we believe certain non-agency residential mortgage-backed securities (RMBS) structures may outperform in a high-volatility interest-rate environment.

We highlight two such opportunities below.

1. Recent-vintage AAA non-qualified mortgage

Most agency mortgage-backed securities (MBS) comprise a pool of loans that have guarantees from a government sponsored entity, such as Fannie Mae and Freddie Mac. Underlying loans are required to conform to several underwriting criteria set by the agency. 

A non-qualified mortgage (non-QM) is a relatively new sector in the residential mortgage credit space. Non-QM loans lack the backing of one of the government agencies and carry a degree of credit risk. The borrowers behind non-QM typically include self-employed individuals or people with a dented credit history. The deals also tend to have a high percentage of investor loans that are underwritten based on their ability to generate cash-flow through rents to pay debt obligations, which is known as the debt service coverage ratio (DSCR)¹.

The highest-quality AAA bonds issued in 2023–2024 offer a more attractive spread than alternative fixed income instruments. The bond’s payment schedule has a coupon step-up feature that provides investors looking for less price sensitivity to changing interest rates (or shorter duration profiles) with limited risk that the bond’s prepayment schedule will lengthen beyond current projected expectations (also known as extension risk). Typically backed by a pool of loans with weighted average coupon greater than 8%, these bonds offer spreads² between 1.2% and 1.4% above US Treasury yields, with only 1-2 years of duration.

The following features of the pool of loans and bond structure may also be attractive to investors:

• Non-QM collateral of borrowers who do not have typical loan application documentation, along with investor DSCR loans with prepayment penalty features, have less sensitivity to changes in prevailing mortgage interest rates (flatter S-curve).
• In a falling interest-rate scenario, the rise in prepayment speeds is slower and more gradual compared to a structure containing agency MBS.
• Starting in mid-2022, non-QM deals added a feature in the structure where the interest rate paid to investors increases (steps up) after a predetermined number of years. Thus, if a principal of the deal is not paid by the issuer (called) four years after issuance, the coupon on the bond steps up by 1%. This feature incentivizes the issuer to call deals and offers extension protection to the underlying investor.
• Deals issued in a higher interest-rate environment have larger outright interest payments on the bond, thus further incentivizing the issuer to call the deal, as they can reissue bonds at a lower coupon rate. This limits extension risk for investors (convexity).
• On the risk side, prices of non-QM bonds would fall more in a credit selloff event than agency MBS prices. However, the lower sensitivity to increasing spreads should limit the mark-to-market pricing impact.

2. Prime jumbo and agency floaters with high coupon caps

We think floating-rate coupon loans that have a cap on coupon payments are an attractive option in a volatile interest-rate environment, particularly in certain prime jumbo (high-quality, high-balance) and agency structures. Deals issued with mortgages that have an interest rate between 7% and 8% are “in-the-money” at current mortgage rates and we expect will prepay at faster speeds.

Further, the coupon caps are also in the 7%‒8% range. As such, a bond with a coupon set at the secured overnight financing rate (SOFR, a market standard) plus 1.25% (SOFR +1.25%) and a 7.5% cap should continue to pay a floating-rate coupon if SOFR stays below 6.25%, thus providing low convexity³ versus agency MBS. (SOFR’s current level is ~4.66%.)

On the risk side, if long-term interest rates continue to rise and mortgage rates reach 7.5%‒8%, these bonds could extend up to 5-7 years. However, the floating-rate nature of the bonds should limit the mark-to-market pricing impact.

As shown in the graph below, both opportunities offer better interest-rate convexity than agency MBS, and thus also offer a lower option cost. We think investors should consider these non-qualified MBS as a low-convexity, higher interest-rate carry⁴ alternative.