Fixed Income

Property has been the backbone of many investment portfolios and many wealthier investors are ranging further than ever in search of yield into sectors such as secured mortgages. A related area that is also getting new funds is residential mortgage-backed ­securities (RMBS).

Accessing deals offered by commercial and residential property developers can be attractive but single developments come with substantial risk and so while those high returns look attractive, you are getting paid for a reason.

High yield equates to high risk. Investors in the higher-risk spectrum should expect volatility and possible illiquidity.

In common with secured mortgaged, RMBS investments are underpinned by property but are generally less risky.

For example, imagine tapping into bank expertise in assessing risk and lending and being able to invest in residential mortgages that had already gone through a bank approval process.

RMBS are issued by many banks and non-bank financial institutions in the over-the-counter fixed income market. The institutions issue RMBS to recapitalise their balance sheets.

Individually, residential property is a relatively illiquid asset, but by pooling the mortgages into a trust then splitting them into smaller, marketable classes, they become much more attractive.

RMBS is a significant, established market. As at June 30, there was $121.5bn outstanding. Last year more than $25bn of RMBS was issued.

Typically, an RMBS will consist of hundreds and sometimes thousands of home loans and each marketable class of RMBS, known as a tranche, has varying degrees of risk and return. Investors can target the tranche to reflect their risk or return objective.

In this way, the tranches act like a normal company structure where investors with the lowest risk appetite target the senior bonds sitting high in the structure that are repaid first. Those wanting higher returns take greater risk and invest in lower tranches that are repaid over a longer time and are more susceptible to loss.

Every RMBS is different and credit rating agencies will analyse the underlying mortgages, provide an assessment to investors of the pool and also ­assign a credit rating to each ­tranche.

RMBS pass through the principal repayments from the mortgage pool, unlike bonds that pay principal at maturity, so investment terms can be quite short, ­especially for the highest-ranked levels. Based on historic data, the credit rating agency will assign a weighted average life figure to each tranche that is the expected term of the investment. Interest is floating, paid monthly and tied to the BBSW, which is great for regular income-seeking investors.

These securities are typically very low risk due to the following:

● Borrowers usually have equity in the properties, somewhat protecting investors from a downturn in the market should the borrower default. RMBS data will show the average loan-to-valuation ratio (LVR) of the under­lying mortgages. The lower the better. The other factor to look for is seasoning, the average length of time of the loans in months. The higher the better.

● If any of the borrowers’ default, mortgagors are still responsible for repayment of any outstanding debt.

● Lender’s mortgage insurance is often taken out for higher LVR loans.

● The trust will build reserves and these are used to repay investors in case of non payment.

● Higher-rated RMBS tranches have a buffer of subordinated tranches that must take on any losses and be wiped out before higher-rated tranches.

● Investments derisk over time as principal is returned to investors and tranches are repaid.

● There is often inherent diversification in RMBS given div­erse geographic locations, borrower demographics, owner-occupied or investor borrowing and type of dwelling.

Nonetheless, RMBS are complex investments. While tradeable, they can also be illiquid.

To participate you will need to be a wholesale or sophisticated investor and find a fixed income dealer. Standard minimum transactions are $500,000 but dealers are willing to split parcels into $50,000 or $10,000 lots.

As published in The Australian on Saturday 7 September 2019



Comments

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Justin Sazegar

Sounds a lot like the CDOs which brought the financial system to its knees during the GFC.

Elizabeth Moran

Hi Justin, this is a common misconception. These are very different investments. To start, there is no recourse for US borrowers if they default on a home loan, they can walk away from the property and are not liable for any debt. Totally different here, where mortgagees are responsible for the entire debt. Also with higher LVR loans the banks will take out lender's mortgage insurance, so in the event of default, the bank expects the insurer to make up the shortfall - a significant protection for Australian RMBS investors.

Michael Whelan

Elizabeth - thanks for your article (which I also read in The Australian !). It’s good that our relatively ‘safe’ RMBS products are getting some publicity especially for fixed income investors, retirees, superannuants, etc. I think Justin raises a valid question re: CDO which you have answered by mentioning the positive mitigants as opposed to the structural (multi-tranche) aspects where there are some similarities.