Written By: Alistair Wilson
The reputation of asset-backed securities has taken something of a hit as a result of global economic woes. Alistair Wilson of TwentyFour Asset Management outlines why ABS provide an attractive opportunity for investors
Up to a few years ago Abs would have been best known as something grown to perfection on Venice beach and, one suspects, little associated with the investing community let alone local authorities. In more recent years, as an acronym for asset-backed securities, it has become rather better associated with the struggles seen in the global economy. The question is whether these associations are truly fair and do they actually present an enticing investment opportunity for pension schemes.
Figure 1 outlines the current potential investment return for holding a specific class of ABS, namely UK Residential Mortgage Backed Securitaies, those backed by UK homeowners, compared to government Gilts over the next five years. At this moment in time, 5-year Gilts are yielding around 1% and this compares to a yield of 5% for a portfolio of the highest quality, AAA and AA rated, RMBS. This is the equivalent of a total expected return of 24.0%, compared to just 3.8% for holding Gilts, over the lifetime.
The low returns currently provided by Gilts are predicated on their current safe haven status, supported by the balance sheet of the UK government. Yet we have seen many sovereigns struggling with the level of their debt in the current environment and, whilst the UK has maintained its AAA rating, our current financial position is not so different from other struggling countries. Further down this article we model what it would take to “break” the RMBS example in the graph, and it is easy to see that the UK government is more likely to default on its debts than a bond supported by a large basket of UK homeowners.
Apart from the attractive yields available from ABS in comparison to Gilts, they also give investors protection against interest rate rises as they pay a coupon based on prevailing LIBOR. An investor’s yield will, therefore, be closely correlated with any rise in LIBOR (which is, in turn, closely correlated to the base rate). Currently, the gross yield on TwentyFour’s Monument Bond Fund portfolio is approximately 4.0% plus LIBOR, therefore if base rates were to return to nearer the long-term historic average, assuming no changes were made to the fund’s portfolio, this yield could be expected to rise to around 8-9%. This makes the asset class ideal for schemes looking for interest rate protection and a strong alternative to Index-Linked Bonds.
Our funds tend to invest in high quality (AAA/AA rated) UK, European and Australian RMBS avoiding the US RMBS that “blew up” during the credit crisis. There are some important key differences between the markets in which we invest and the US.
The first key difference is that in the US there is no concept of “prime” RMBS; all lending in RMBS deals is non-prime, meaning they are backed by either “Alt-A” mortgages (i.e. those that are non-conforming in some way, often requiring limited documentation) or “subprime”. Secondly, in the US the home owner tends to be able to walk away from the property and debt without being pursued for recourse, even when there is negative equity – the so called “jingle mail”. Thirdly, US RMBS are sold on and packaged away from the originating banks, removing any alignment of interest between the borrower, the lender and the debt. Figure 2 below summarises the key differences.
The level of protection for investors is very high as there are several layers of defence before a AAA or AA bond holder is impacted by any nonpayments by the underlying mortgage borrowers. Even a lower-rated BBB bond will have to see extreme levels of non-payment before there is likely to be a default. According to the credit rating agency Fitch, of the outstanding capital in investment grade European RMBS at the start of the credit crisis, losses of just 0.4% have been incurred or are expected. If Spanish transactions are removed these losses drop to just 0.1%!
Loss rates are low first and foremost because any RMBS is ultimately backed by a pool of housing stock in which the home owners will themselves tend to hold equity. The average loan-to-value ratio of individual mortgages backing a typical RMBS security is in the region of 60-70%, meaning the average home owner will have to see a large fall in house prices before moving into negative equity. Even at this stage, an owner is unlikely to stop making payments, as they tend not to want to walk away from their own home, and in any event will remain liable for any debt remaining following a repossession. These factors provide very significant protection to the bond holders as they greatly reduce the likelihood of the bond cash flows being affected. Moreover, as we will see below, even larger falls in house prices would be required before the capital of any bond is put at risk.
However, this is not the only protection built into the structures of these bonds. Before any losses on the underlying mortgages can impact the bond holders, the bank that issues the bonds first has to take a hit through the “excess spread” it receives when issuing the bonds – the excess spread being the margin between the yield of the actual mortgages in the bond and the coupon the bond pays. This excess spread is taken by the bank and is used primarily to cover any losses. Additionally, a reserve fund is built into the structure of the bond to absorb further losses over and above the excess spread. These combined can typically account for a further 12% of losses in the underlying mortgages pool. It is only then that the BBB notes start to see losses, followed by AA and, lastly, AAA notes.
Stress-testing on individual bonds allows us to see how far losses have to move before a bond holder is likely to be impacted. A sample stress-test, using highly conservative assumptions, is shown in Figure 3. In this case, only if the housing market dropped in value by 70% overnight and 25% of homeowners defaulted on their mortgages simultaneously, would we expect to suffer loss of interest or principal on any AA or AAA rated bonds.
To put this into historical context, the market value decline from peak to trough seen in the housing market slump between 1989 and 1993 was just 20%, with the worst year for foreclosures (1991) being 0.78%. The level of foreclosures in 2010 was 0.31% with a (currently forecasted number) for 2011 being 0.36%.
It would be interesting to make a further comparison with Gilts at this stage. Whilst largely hypothetical, at what point would the UK government be downgraded to AA, A, or beyond? At what stage would we need to ask for help from the IMF? It would be likely to be well before the housing market fell by three quarters and one in five of home owners lost their property.
A further question is what happens when interest rates rise from their current lowest ever rates, thereby putting pressure on homeowners, for whom current rates are generally affordable? The answer is that while rate rises will certainly put further stress on households and a greater level of arrears is likely to be seen, some of which will ultimately lead to foreclosures and therefore some losses, these losses are likely to be borne by homeowners and in the banks’ margins rather than in the bonds that are being discussed. The huge amount of protection embedded into the senior notes means that a rise in rates is actually welcomed by the senior note holders as this serves to increase returns as coupons are linked to interest rates, without a material increase in credit risk.
Whilst credit risk and interest rate risk look so compelling, it is impossible to move away from market risk. It is the latter here that has currently made the investment case so compelling, especially for longer-term investors who can hold investments through periods of potential market turbulence, in the knowledge that their investments are so robust.
There is no other market in which an investor can see such a high level of granularity in the investment they are making. This allows an investor to construct models analysing the typical loan to value ratio, loan size, average life of the loans and current loss rates. Monitoring and modelling are fundamental as they highlight early signs of credit deterioration as well as relative value, giving an opportunity for a skilled active manager to perform with confidence. It is also important that all RMBS are stress tested on their ability to repay principal and interest in case repossessions do rise significantly.
Whilst the RMBS market does not compare in size to the government bond market, the European markets account for bonds of approximately €800 billion. The market is further broadened by other overseas territories, with Australia specifically meeting our criteria to make them investable. The US market, whilst large, is currently not one that forms part of our investable universe due to the issues outlined previously. So whilst not as large or liquid as government bond markets, the RMBS markets are a significant part of the fixed income universe and trade in the same way as any other part of the market. One of the priorities when making any investment is to ensure on-going liquidity so that risk can be removed quickly and, in the case of our pooled fund, to allow daily dealing.
In conclusion, ABS give a very real alternative to more traditional fixed income asset classes. At a time when the status of government bonds is challenged as never before, they offer an attractive yield whilst also delivering protection against future interest rate rises. There are no gym visits needed to develop these ABS. By providing a very safe prospect of receiving both the coupons expected during the life of the bond and the capital back on its maturity (the ultimate goal of any fixed income investment), local authorities can see gains with a minimum of pain.