Investor confidence has returned to the RMBS market and this is reflected in the issuance volume and pricing. Despite a contraction in spreads, RMBS remains attractive from a relative value perspective. Here we take a look at some recent developments in and performance of the sector.
Recent developments
Extension provided to hardship loans
In early July, APRA announced an extension to the capital treatment of loans with repayment deferrals due to hardship. APRA had initially announced that loans deferred for a period of up to six months need not be treated as being in arrears for capital adequacy and regulatory reporting purposes. The additional deferral period will see this allowance being extended to March 2021.
What this means for RMBS transactions is that it is not very clear as to how the underlying collateral is performing by just looking at arrears figures. However, the longer a borrower is allowed a period of respite, the more likely it is that the borrower will either be able to instate a repayment plan, either through selling or refinancing.
RBA study finds determinants behind mortgage losses
The RBA recently released a very insightful paper that shows that there are two main drivers behind mortgage defaults. The premise behind the study is that foreclosure is a separate process to entering arrears. This is labelled a ‘double-trigger’ hypothesis whereby foreclosure can be explained by a combination of two triggers. The paper states that the first trigger is a change in the borrower’s circumstances that limits their ability to repay their mortgage (e.g. unemployment or illness); and the second trigger is a decrease in the value of the property that causes the loan to fall into negative equity.
It is important to note that both triggers are needed in order for the loan to experience a loss. With only the first trigger, the borrower may enter arrears but can profitably sell the property to repay a loan and with only the second trigger, the borrower can continue to repay the loan despite being in negative equity.
Arrears and hardship data
Data released by S&P and APRA for the period up to May 2020 shows that arrears have remained relatively stable and the growth in hardship loan approvals has plateaued since mid-March, though the impact of the second lockdown in Victoria on these statistics is as yet unknown.
Source: S&P Global Ratings
While these numbers look quite elevated, it is important to note that each loan that has entered hardship will not necessarily default. Many of the loans that have been granted hardship relief continue to make repayments on the mortgages albeit at a lower rate than their minimum monthly repayments. These loans are being assessed regularly by originators to check whether they still meet the criteria to remain in hardship or whether the borrowers can be transitioned back to full repayments.
Excess spread and liquidity
Despite a tough few months for mortgage holders there have been no charge offs to any tranches on any RMBS transactions. Excess spread, which is the difference between the income received by the RMBS trust and costs (ie note repayments) remains elevated. This is an interesting development as mortgage rates are generally based off the RBA cash rate, which has been at 25bps, but the interest paid to RMBS noteholders is based off the 1 month BBSW, which has slipped below the cash rate and has been at 10bps since April.
These high levels of excess spread have been able to absorb any losses in the pools.
Source: Bloomberg
Pricing and relative value
The primary RMBS market has been very active with 8 RMBS transactions priced in the last two months. The pricing trend has been supportive of issuance as these transactions are paying higher coupon margins compared to pre Covid-19. Below is an example of a pre and post Covid-19 issuance by Columbus Capital. The underlying collateral in both pools is comparable but despite the short weighted average lives of the recent issuance, the margin on these bonds is higher making them stellar relative value for the rating.
Source: FIIG Securities
The table above highlights the pricing anomaly for the same underlying risk, especially in the investment grade rated part of the structure. The A-rated Class C notes in the pre Covid-19 Triton RMBS transaction had a weighted average life of 4.3 years and paid a coupon margin of 250bps over 1mBBSW, whereas in the most recent Triton RMBS transaction (priced in June 2020), the Class C notes had the same rating but had a weighted average life of 2.7 years, almost 1.5 years shorter, yet paid a coupon of 350bps over 1mBBSW.
This is an arbitrage worth taking advantage of. These new transactions have mortgages with similar risks as the older deals but are pricing at a much more attractive level.
Conclusion
Both primary and secondary RMBS markets remain active with participants remaining relatively comfortable with the underlying collateral. There have been a number of initiatives announced by the RBA, APRA and the government that are supportive of the mortgage originators, borrowers as well as RMBS investors.
At this stage we remain comfortable with the investment grade rated tranches of RMBS transactions, especially the Class C notes that are attractively priced compared to A-rated corporate bonds.