Senior ranking tranches of Residential Mortgage Backed Securities (RMBS) provide superior returns when compared to equivalent rated bonds and have the added benefit of natural risk reduction through amortisation.
RMBS is a unique asset class secured by residential mortgages. The underlying investment of 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, eg Liberty, NAB or Bluestone 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.
Due to the structural complexity of these securities, they tend to trade at more attractive levels than equivalent rated corporate bonds.
The recent RMBS transaction by Bluestone Group, Sapphire 2019-1, was issued with very attractive margins on the senior notes. Bluestone originates non-conforming
RMBS, which can pay higher margins than equivalent prime transactions.
For a refresher on RMBS, please refer to our beginner’s guide to these securities.
Last week, the Class A2 notes of Sapphire 2019-1 RMBS were issued at a coupon margin of 1mBBSW+2.15%, which equates to a first coupon above 3.80%, and that’s for a security with the same rating as the Australian government.
We believe this investment option is a good way for clients to get investment grade bond exposure without sacrificing yield.
Achieving an investment grade rating in RMBS
In order to achieve the same rating as the Australian government, a RMBS tranche needs to be able to withstand some extreme property price declines and losses. For example, one of the ratings agencies assumes 11% default frequency for loans with 80% loan to value ratio (LVR) and 25% default frequency for loans with 95% LVR, along with various stress factors applied for location, property type, borrower type etc. What this stress testing means is that in order to achieve this rating, the tranche has to be able to absorb severe property market underperformance, much worse than what we have experienced in the past few months.
The Sapphire 2019-1 Class A2 notes form part of the senior Class A notes within the RMBS. This means that these notes receive priority in repayment and are the last to be allocated any losses. There are six tranches of notes (totalling AUD56.4m) as well as various reserves that sit below and are junior to the interest of the Class A2 noteholders.
The transaction has mortgages issued by Bluestone Limited, a specialist lender to near-prime and non-conforming borrowers. The underlying pool has predominantly metro loans with a weighted average LVR of 67.5% and no loans with a LVR > 85%.
The notes will amortise, i.e. repay principal, starting from January 2020 until they are called in April 2023. This has the added benefit of reducing exposure to the pool as principal is repaid to the Class A2 notes. The chart below shows the expected outstanding principal on these notes per month until the call date on an AUD100k investment.
Source: FIIG Securities, Bloomberg
Note: Principal repayment is based on a set of assumptions which may vary
Investment opportunityThe highly rated AUD investment grade universe is largely made up of government and semi-government bonds with low yields, for example, an Australian government bond, with 3 years to maturity, trades well above par at AUD114 and offers yield of 1.28%. An alternative investment option is term deposits, which have lower risk due to the government guarantee, but also have lower liquidity (difficult to break a term deposit) and lower returns than senior RMBS.
As the table below shows, investors can gain exposure to the same rating as the Australian government bonds with much higher yields by investing in senior tranches of RMBS, such as Sapphire 2019-1 Class A2 notes.
| Rating | Maturity/WAL | Price | Margin | Yield |
| Sapphire 2019-1 Class A2 | Investment grade | 2.70yrs | 100.30 | 2.03% | 3.60% |
| Australian Commonwealth Government | Investment grade | 15-Jun-22 | 114.24 | -0.30% | 1.28% |
| NSW T-Corp | Investment grade | 1-Mar-22 | 112.63 | -0.02% | 1.52% |
Source: FIIG Securities