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 yield 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 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 equivalently rated bonds.
In this note, we highlight some basic features of these securities and the Australian RMBS market.
1. RMBS are secured bonds
The underlying assets supporting an RMBS transaction and generating its required cash flows are residential property loans extended to borrowers and secured by an underlying property (house, unit or land). The investors in the notes issued by a RMBS transaction collectively have the benefit of security over all these loans (and indirectly to the underlying properties). Furthermore, the ongoing interest and principal payments will directly flow through to the structure and can’t be redirected in the unlikely event the mortgage originator becomes bankrupt.
The underlying property loans have generally been originated by the transaction sponsor (for example, loans in a Kingfisher transaction were initially extended by ANZ Bank) and the RMBS transaction will inherit all the rights of the bank against the borrower. This includes not only the ability to pursue all avenues to recover borrowed money (even if the value of the property is lower than the loan – a significant difference compared to the US) but also the benefit, where relevant, of additional security provided by the borrower, including any lender’s mortgage insurance policy.
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 as they ultimately drive the overall credit quality of the loan portfolio. For example, loans extended to owner-occupiers are generally less risky than investment loans.
While every transaction has a unique portfolio of loans, there is considerable amount of historical data that provides indication of the impact of a given variable on performance. For example, borrowers with casual employment are deemed 3x more risky than borrowers with regular salaried employment. Interest-only loans are considered 25% more risky if the interest-only period is between five and ten years.
These adjustments allow investors to undertake an analysis to ensure an adequate reflection of the underlying loan characteristics, which ultimately provide the basis for a comparative assessment against other similar transactions. This is what allows credit rating agencies to maintain consistency of ratings across transactions and explain why two widely different RMBS pools can support tranches of notes with similar ratings (noting the tranche sizes would likely be materially different).
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 incurred an unrepaired 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.
If we consider all RMBS transactions issued since 2010 and still outstanding, 14 are rated lower than initially (no more than two notches) while 214 are rated higher than their original rating (and the ratings of the remaining 775 unchanged). These statistics are based on ratings from S&P Global Ratings, noting that those issued by Moody’s are showing consistent trends (five lower, 107 higher and 219 unchanged).
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 expenses of the special purpose vehicle (SPV) that administers the RMBS. Any losses to noteholders are remediated out of the excess spread on an ongoing monthly reconciliation before it is paid to the originator of the deal.
- 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.
- 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 in a ‘waterfall’ structure, set at the issue of the bonds. Principal is first paid to the most senior tranches and then may be pro-rated to more junior tranches if certain conditions are met.
7. Declining risk over time
RMBS investments naturally de-risk 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
RMBS securities generally have a legal maturity longer than 30 years to match the tenor of the longest underlying mortgage in the pool, 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. For regulatory reasons, RMBS originated by banks will have a call option that is tied to the size of the portfolio whereas transactions from non-regulated financial institutions will include a call tied to a particular 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. Government support
The federal government, the Reserve Bank of Australia (RBA) and the Australian Prudential Regulation Authority (APRA) understand the importance of the RMBS market for the Australian banking and financial systems and the liquidity it provides, since this allows mortgage originators access to a large pool of funding to support ongoing lending to residential property borrowers. A drastic cut to this source of funding would have a material negative impact on property prices, which would then likely have flow-on effects to the broader Australian economy.
Evidence of this support includes the provision of liquidity during the early part of the COVID-19 pandemic to ensure continued availability of credits. The government, APRA and the RBA also supported the concept of COVID-19 hardship for borrowers while not penalising banks for these repayment holidays. The Australian Office of Financial Management also participated in a number of RMBS transactions (in both the primary and secondary markets) to provide continued liquidity, especially for non-bank lenders (since regulated entities could access preferential funding directly from the RBA).
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.