Private clients like regular cashflows and capital preservation, which RMBS provide. Unlike fund managers, they are less concerned about mark-to-market price moves. Here we look at why higher rated notes of RMBS transactions remain attractive investments satisfying both these priorities
Background
Recently, there has been significant press dedicated to declining property values, leading clients to question investment in RMBS. It’s important to note that the main focus is the Sydney and Melbourne markets over 2018. While the price decline has somewhat dented confidence, we believe that the correction to date has been orderly and necessary for the overheated property market.
At FIIG, before we make any RMBS tranche available to clients we research the metrics. This year, we have rejected a number of new originations, preferring older, seasoned RMBS tranches with lower loan to valuation ratios. The FIIG investment strategy team analyses all securities made available to clients to understand the dynamics of not only the pool, but also the originator’s policies and criteria for a mortgage.
Investment strategy
Investment grade rated tranches of RMBS transactions continue to offer attractive relative value for investors. These notes benefit from a strong rating, a diverse pool of mortgages and, importantly, are secured exposures against first ranking Australian mortgages. This beginner’s guide to RMBS is an excellent note to help you to further understand the mechanics of these securities.
Typically, the weighted average loan to value ratio (LVR) of a pool of mortgages underlying RMBS is not higher than 70%. This provides an additional buffer to these securities beyond subordination provided by lower ranking tranches in the capital structure.
In simplistic terms, at 70% LVR, a mortgage can withstand a 30% decline in property price before it will suffer a dollar value loss.
Property market performance
The recent property market correction in Australia has been observed in other global markets. A culmination of a number of factors resulted in the slowdown:
- Reduced offshore money (China) investing in Australia
- Prudential regulation resulting in a slowdown in the supply of credit and loans
- Royal Commission into misconduct in banking
While the property market correction has seen flat to negative changes in property prices since the beginning of 2018, we believe the correction to date has been orderly. The first chart below (left) show the monthly change in residential property (houses and apartments) prices for the five largest Australian capital cities (Sydney, Melbourne, Brisbane incl. Gold Coast, Adelaide and Perth). This clearly shows the slowdown in property prices in 2018. However, this chart fails to capture the capital gains experienced by dwellers and investors prior to 2018.
In order to illustrate the compounding effect of this capital gain, we have put together a second chart (right) that shows the indexed value of a property assuming it was purchased at 100.00 in January of each of the following years – 2008 (11 years ago), 2011 (9 years), 2013 (6 years), 2015 (4 years), 2016 (3 years), 2017 (2 years), and 2018 (year to date). As the chart illustrates, the price movements for 2018 are closely tracking the experience from 2008 and 2011.
Source: FIIG Securities, Bloomberg, CoreLogic
It is very difficult to predict how property prices will behave going forward, although we continue to be optimistic in the longer term. A correction in property is often driven by adverse economic conditions or changes to interest rates, however, the decline in prices this time around has occurred without either of these catalysts being present.
Below we outline factors that could influence prices going forward.
- Regulators, including APRA and RBA, remain supportive of the residential property sector and are likely to stimulate the market with loosening of prudential standards or with interest rate cuts, if needed.
- Fundamental economic factors remain robust in Australia. The economy, as a whole, is performing well with strong employment and growth.
- Employment is a key leading indicator of property market performance, strong employment usually correlates with low defaults.
- Given we are currently in an election cycle, the economy is likely to benefit from additional spending, especially in infrastructure, which should create further jobs.
- Ongoing low wages growth somewhat offsets the economic factors above. Lower wages affect the serviceability of a mortgage.
- Population growth is expected to continue in Australia, specifically in Sydney and Melbourne, through net positive migration. Population growth drives demand for housing.
- The recent property price decline has seen many potential purchasers, both owner occupiers and investors, stay on the sidelines waiting for some stability before entering the market. This has driven the demand for housing credit lower. This is offset, however, by those potential purchasers who were ‘priced out’ of the market during the rapid price appreciation who should now be able to enter the market again.
- Reduced supply of credit has heavily affected the final demand for certain types of loans such as investment and interest only. This reduced demand has in turn affected prices.
- Strong supply of stock, especially with strong construction in Brisbane, Melbourne and Sydney, could result in a lot of stale housing stock on the market.
- Performance of RMBS to date has been strong, arrears are low, though WAL is extending due to lower prepayments Default rates have remained low through previous property market corrections and this trend is expected to continue this time around.
Conclusion
How all the factors noted above will impact property prices is not easy to forecast. Fundamentally, property markets should see some stability in 2019, however, behaviours of lenders and borrowers will ultimately drive price movement. If we continue to see further declines, the magnitude of price falls will need to be assessed in conjunction with economic conditions to understand the impact on RMBS.
In the medium term, we believe investment grade rated tranches of RMBS should continue to perform well. These secured exposures offer good relative value when compared to similarly rated unsecured exposure to financial institutions.
Please contact your relationship manager for current availability of RMBS in the secondary market or contact me at asmita.kulkarni@fiig.com.au with any specific questions about RMBS.