A beginners guide to tranches in mortgage-backed securities
RMBS are a historically low-risk investment and, in Australia, no-one has ever lost a dollar of their capital through a prime RMBS default.
So what are they? In a nutshell, residential mortgage-backed securities are a type of debt security that is secured by a pool of residential mortgages. An estimated one in 10 home loans is funded by RMBS. If you've never heard of RMBS before, it's because they're almost exclusively bought by funds and institutions (like banks).
RMBS have two main purposes. On the one hand, they can help lenders (banks and other financial institutions) to source funding for their mortgage lending. On the other hand, they give investors access to the residential property mortgage market.
Home loans are normally private transactions that stay on a lender's balance sheet for the duration of the mortgage, which means all the capital that is paid is tied up. But by pooling many home loans together into a 'security', this capital is moved off the lender's books and made available. Essentially, RMBS are debt securities that investors can purchase from lenders, with the intention of earning interest on the entire pool.
Investors in these securities are then paid as the home loans are repaid. How well these debt securities perform is determined by the repayments made by borrowers from this pool of loans - which brings us to the tricky topic of tranches.
What is a tranche?
The average home loan size is $250,000. Groups of these home loans are bundled together in groups of hundreds or thousands and sold to institutional investors as RMBS bonds. These bonds consist of multiple tranches, each of which has a different credit rating based on seniority which is determined by rating agencies.
A typical RMBS ranges in overall size from $500 million to $1 billion. The word tranche is French for slice, series or portion.
The transaction documents usually define tranches as different “classes” of notes, each identified by letter (e.g. the Class A, Class B, Class C notes) with different rights.
Tranches are packages or bundles of home loans which are sold to institutional investors. Investors can then target a package or bundle of home loans (a tranche) based on their investment goals and the risk of a tranche. The risk, or credit rating, of each tranche is usually determined by an accredited credit rating agency.
If an investor wants a lower risk investment option, they may opt to buy the higher tranches. Higher tranches earn less interest but they're insulated from the risk of default of the underlying asset pool because any losses are absorbed firstly by the lower tranches beneath it. Investors can also receive their money back sooner with higher tranches. Conversely, lower tranches have little to no tranches below them to absorb losses which makes them a riskier investment. Because of this, they tend to earn more interest than higher tranches.
As with any investment, deciding to go with a higher or lower tranche depends on the amount of risk you're willing to take.
Firstmac's High Livez investment fund
High Livez gives everyday investors access to RMBS which is normally only available to financial institutions. The High Livez product is generally suited to investors with a medium-term investment horizon of three to five years.
You can invest in High Livez with as little as $10,000. There are no fixed terms, no entry or exit fees.
A typical tranche structure is broken down into three tranches:
- Tranche A has the highest possible rating and represents about 90% of the RMBS pool. Tranche A typically earns about 1.5% above the Bank Bill Swap Rate (BBSW).
- Tranche AB represents about 7% of the RMBS pool and earns 2.5% above the BBSW.
- Tranche B represents about 3% of the RMBS pool and earns 4% above the BBSW. Firstmac's High Livez investment fund buys lower tranches for yield and higher tranches for liquidity.
The B notes where the High Livez fund invests has a Category 2 risk rating which means the fund has a very strong capacity to meet fund expectations. How does it meet this high-quality rating? It benefits from the security (the other tranches) beneath it and the borrower's equity in their home. Firstmac's RMBS investments have on average less than 80% LVR.
The B notes where the High Livez fund invests also meets this high-quality rating through mortgage insurance, as insurers like QBE guarantee the loan security. This means that if a borrower defaults on their mortgage, the insurer picks up the tab. Then there's the surplus margin of the pool.
Visit this page for more information on High Livez.