Wednesday 20 March 2019 by Asmita Kulkarni Opinion

Suncorp RMBS – a bond failure, it was not

One of our distinguishing factors and a key value proposition is the amount of experience and expertise our research and strategy team members have in analysing bond investments, especially as Australian mainstream and specialised media has historically shown a bias toward the equity market.

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More often than not, what is negative for an equity investor is actually positive for a bond investor. One of the recent examples of this was our ability to refute a recent article in The Australian discussing Residential Mortgage Backed Securities (RMBS) and provide our clients with an accurate picture of what actually unfolded and what this means for their investments.

RMBS, like corporate bonds and other credit exposures, need the ability to understand features of a structure, which include understanding terms and conditions set out in documentation. Unlike equity investments that are governed only by the constitution of a company bond investments are governed by terms and conditions and other contractual arrangements, unique to each bond.

At FIIG, we conduct stringent analysis on the underlying credit quality as well as the structure of bonds, including RMBS. It is important to highlight the importance of this process, which is often misunderstood by the market. It is through this rigorous level of analysis that we gain comfort in making investment options available to clients. For example, we will look at if a bond is secured or not, what covenants are present to protect the bondholders’ interest and any other factors that are relevant for the purpose of our analysis.

Earlier this month, The Australian published an article titled, “Suncorp mortgage bond failure ‘a canary’”. The article focussed on features of RMBS that are quite common but require analytical expertise to understand.

Below, Asmita Kulkarni, from our Investment Strategy Group, discusses the intricacies of RMBS and why the article was inaccurate.
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On 4 March 2019, Suncorp made an ASX announcement noting that one of its RMBS transactions, Apollo Series 2010-1, had hit an arrears based trigger meaning principal repayment in the transaction will be reverting back to sequential payment (only the most senior notes receive principal) from pro rata payment (all notes receive their proportional amount of principal). The bank made no comments. 

RMBS investors are familiar with arrears and time based triggers, whereby a transaction pays any principal received from underlying mortgages to the senior tranches only until a certain period of time (usually 2 years) has passed and arrears remain within pre-specified levels. While an issuer would want to pay its most junior tranche faster (as they attract higher interest rates), the structure recognises that the most senior tranche needs to be prioritised initially until a track record of performance has been achieved.

In the case of the Apollo transaction, it is important to note that, unlike the claims in the article, reverting principal repayment from pro-rata to sequential is not a "bond failure" and it certainly is not "the first local mortgage bond to encounter difficulty", as principal repayments in transactions switch around based on triggers quite frequently.

The amount currently outstanding for this transaction is down to 12% of the original amount issued and Suncorp will, in all likelihood, clean-up the transaction through a call option when the outstanding balance reduces to or below 10% of the original AUD1bn issued. At that point, all investors will be repaid any capital invested. It is not unusual to see a rise in mortgage arrears in pools near their clean up calls as a small number of outstanding mortgages create ‘noise’. Furthermore, the vintage of the loans in this pool generally display a higher level of arrears – that is not to say they have higher defaults or losses.

This pool currently has 1,008 mortgages, with weighted average seasoning of 148 months (12 years), weighted average loan-to-valuation ratio (LVR) of 50% and average loan balance of AUD118k. Finally, the pool is fully covered by lenders mortgage insurance (LMI). Any loan defaults in the pool will first be covered by the sale of the property. At 50% LVR this should provide substantial loss coverage. Any outstanding principal loss after the property sale will then be claimed via LMI, meaning it is very unlikely that noteholders will suffer any capital loss.

The notes continue to pay interest as scheduled and will repay in full when Suncorp makes the call.

We remain comfortable with senior and mezzanine tranches of RMBS as well as selective junior notes.