This article was originally published on 3 July 2018 and modified on 10 July 2019.Residential Mortgage Backed Securities (RMBS) are a popular choice for wholesale investors as they can choose the risk and return they seek and the securities offer a premium over similarly rated corporate bonds. Here we explore some basic features of these securities and outline what makes them different to vanilla corporate bonds.
RMBS transactions offer a premium over similarly rated corporate bonds, making them a popular choice amongst sophisticated investors that are after a higher yield. RMBS are securitised bonds with a tranched capital structure and are considered more complex than vanilla corporate bonds. However, this in return means that investors are rewarded with higher yields compared to equivalent credit rated bonds.
In this note we highlight some basic features of these securities and the Australian RMBS market.
Below is a comparison of yield on three corporate bonds versus the recent RMBS notes of equivalent rating issued by these same financial institutions.
1. RMBS are secured bonds
The underlying investment of an RMBS is a pool of first ranking rights over residential mortgages in Australia, which unlike US counterparts are full recourse obligations. This pool is segregated from the originator of these loans, e.g. Liberty, NAB or Bendigo and Adelaide Bank and is bespoke for the particular security. The underlying mortgages are a ‘closed pool’, meaning no new mortgages can be added to the RMBS following issuance.
2. Underlying mortgages differ in each RMBS
It is important to understand the make-up of the underlying mortgages in a pool including assessment of any concentrations by geography, property type, loan interest type or seasoning. For example, Pool A below is considered as being less risky than Pool B as the underlying loans are considered to be of higher quality:
Pool A: a pool issued by an authorised deposit-taking institution (ADI) lender with weighted average (WA) seasoning in excess of 18 months, WA loan to valuation ratio (LVR) less than 80%, most mortgages secured by houses in geographically diversified metropolitan areas and with principal and interest variable rate mortgages
Pool B: a pool issued by a non-bank lender with WA seasoning less than a year, WA LVR in excess of 80%, concentration by region or in apartments or flats, and mostly interest only, investment and fixed rate loans
The rating agencies always pay specific attention to pool collateral when assigning required subordination (see below) and ratings for a tranche.
3. Capital structure and where your investment sits, matters
As is the case for any fixed income investment, it matters where you sit in the capital stack of an RMBS. More senior tranches or notes of an RMBS, usually the Class A, Class B and Class C notes offer more downside protection than the junior ranking notes. This is because losses in a transaction are first allocated to the junior tranches, after depleting any reserves or insurance claims, before the senior tranches are affected. The lowest level, is typically unrated and deemed equity like.
4. Strong asset class
According to rating agency data, no rated tranche of an RMBS has ever incurred a loss in the past two decades, which highlights the robustness of the structures and other provisions, such as reserves and Lenders Mortgage Insurance (LMI), which provide protection to noteholders.
According to a recently report by Fitch, over the last five years 99% of ratings on RMBS have been affirmed, upgraded or the notes have been paid in full.
5. Many protections for your investment
The main protections offered to noteholders are:
- Hard subordination – this is represented by the proportion of the RMBS (the lower tranches) that rank more junior to a specific note
- Excess spread - excess spread is the difference between the income and the liabilities of the special purpose vehicle (SPV) that administers the RMBS. Any losses are paid out of the excess spread first on an ongoing monthly reconciliation
- Insurance on underlying loans known as LMI – if a mortgage is covered by LMI then any claim from the LMI will be applied to losses before losses are allocated to the notes A
- Any reserves – most transactions typically have a liquidity reserve or other reserves that can be used for payment shortfalls or losses for a period of time
6. Floating rate securities
RMBS notes are floating rate with monthly coupons. Each month, the interest and principal received from the mortgages in the pool are paid to investors. Principal is first paid to the most senior tranches.
7. Declining risk over time
RMBS investments naturally derisk as they repay principal over time. At issuance, the notes follow a sequential payment structure, where the most senior note receives all of the principal until certain triggers are satisfied at which point the structure diverts principal to all notes (except the equity tranche) of the RMBS in a pro rata fashion.
8. Long final maturity but include call options
These securities generally have a legal maturity longer than 30 years to match the tenor of the underlying mortgages, however all RMBS have an embedded call option which allows the issuer to call the transactions when the pool reaches a certain size or on a specific date.
9. Credit quality of the issuers matters
It is important to understand who the originator of an RMBS is. Both banks and non-bank financial institutions issue RMBS in Australia and within non-bank issuers there is a subset of non-conforming issuers. Prime mortgages are loans that meet a bank’s and LMI’s lending criteria, whereas the non-conforming loans fall outside this, meaning interest charged is higher and subordination in a non-conforming transaction is higher for each ratings grade to accommodate the higher risk.
10. Past government support
During the last financial crisis when funding and liquidity were constrained the Federal Government stepped in to support the Australian securitisation market with investments through the AOFM. The government has since progressively sold down its holdings to help sustain the market and in the last year completed the sale. While we cannot guarantee that the government will step in with support should there be another (GFC style) dislocation, we take comfort in noting the importance placed by the government and the RBA on this asset class, which makes up around AUD80bn in outstanding issuance.
In conclusion, we see good relative value in RMBS given the current low level of yields in the market generally. Assessment of each individual pool of mortgages and the structure of the transaction is essential in determining value. Please speak to your contact at FIIG if investing in these bonds sounds attractive.
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