Residential mortgage backed securities (RMBS) now represent better credit quality than pre-credit crunch and offer a clearer outlook than most bonds, according to Twenty Four Asset Management.
The group’s Monument Bond fund recently hit its first anniversary and has produced returns of 7% in its debut year from investing in this asset class.
Mark Holman, the managing partner of Twenty Four, says the fund has only suffered two negative months, May and June, when the team picked up beta from the extreme volatility surrounding the near default of Greece.
“While stress testing for banks and corporates can be subjective, when applied to a typical RMBS structure, the results are very clear”
“The majority [of RMBS] are AAA-rated bonds and secured on large diverse pools of UK mortgages, which typically makes them among the strongest bonds found anywhere in the fixed income universe,” he adds.
“While stress testing for banks and corporates can be subjective, when applied to a typical RMBS structure, the results are very clear. Moreover, given that most deals in the market place benefit from monthly reporting by an independent trustee, the securities lend themselves well to ongoing monitoring and stress testing.”
For a bank to lose money in mortgage lending, two things need to happen simultaneously: a sufficient drop in the house price so the borrower is in negative equity and that borrower then needs to default in order to crystallise a loss for the bank.
“RMBS deals recognise this risk and are structured so that typically it is only the issuing bank’s profit margin in the transaction, known as excess spread, that is impaired by such losses,” adds Holman. (article continues below)
The other key ingredient making the market attractive is relative value, according to Twenty Four.
The average credit spread in the Merrill Lynch Corporate Bond Index is 226 basis points, for a 12 year maturity with a single A rating.
In the Monument fund, the spread is 280 basis points for a four-year average maturity with 80% of the bonds rated AAA.
For investors willing to look at single A or BBB risk, Holman says the spreads are even more compelling.
“While demand is picking up, supply has been very light and therefore the market is shrinking,” he adds.
“The majority of mortgage supply comes from financial institutions, and currently they have a broad range of options to finance themselves that are considerably cheaper than financing through RMBS.”