In this white paper, we examine the overall relative value case for Non-QM as compared with Agency or conventional mortgages. We take a closer look at the convexity profile for Non-QM, along with comparing the credit characteristics relative to Agency mortgages. With relative value a consistent topic in our conversations with clients, we hope this analysis sheds some light on our views, especially in the context of the volatile market environment. As always, we welcome your feedback, and please reach out if you have any questions.
Potential Convexity Advantage in Non-QM
When evaluating relative value in Non-QM, one advantage over Agency loans is the better convexity, or a flatter S-curve profile. The S-curve is the prepayment response function for borrowers at different rate levels or incentives. Looking at the S-curve based on the past 2 years of observations in the chart below, Agency loans, for example, prepaid in the mid-30s CPR (annualized prepayment rate) at 100 bps of rate incentive, whereas Non-QM speeds have hovered around a high-teens CPR. On the other hand, deep out-of-the-money prepayment speeds in Non-QM tend to be slightly faster than in Agency, as shown in the chart below when the X-axis dips below zero.
There are several reasons for this, in our opinion:
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- With alternative documentation underwriting, Non-QM loans have more limited refinancing channels compared with Agency loans, thus reducing the ability to refi at the margin.
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- Underwriting cost/time/complexity: Non-QM underwriting is still a manual and costlier process, whereas automated underwriting systems for Agency loans are well established.
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- For investment property collateral within Non-QM, debt service coverage ratio (DSCR) loans come with prepayment penalties, thus significantly reducing the refi incentive in the loan’s first few years.
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- In the recent environment, Non-QM rates have come much closer to Agency rates. The spread between Non-QM and Agency has shrunk to inside of 100 bps compared with 150-200 bps historically. This has led to slower prepayments in Non-QM loans – down to mid- to high-teens CPR compared with mid-20s CPR historically.
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- Non-QM Bank Statement loans typically cater to self-employed individuals and small-business owners. For those borrowers who are looking to expand their businesses, tapping into their home equity even at higher rates could be a compelling option. We saw this play out in the 2022-2023 sell-off environment, when cash-out refinancing volume was consistent while rate refinancing volume vanished.
Looking at historical data, this relative convexity advantage still held in very fast prepaying environments. During the refi boom back in 2021, conventional Agency mortgages prepaid at 50%-60% CPR on average, even at slightly in-the-money rate incentives. By contrast, Non-QM Bank Statement prepayment speeds generally stayed in the high-30s to low-40s CPR range, while Investor Cash Flow (ICF) loans ramped only to mid-30s CPR.
Non-QM vs. Conventional S-Curve (13-24 Month WALA)
Source: Bloomberg, Fannie Mae, Freddie Mac as of April 2025.
Non-QM vs. Conventional S-Curve (13-24 Month WALA)
Source: Bloomberg, Fannie Mae, Freddie Mac as of April 2025.
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