Pros and cons of RMBS and how to get started
What is RMBS?
An RMBS - which stands for Residential Mortgage-Backed Security - is a form of asset-backed security that's secured by a pool of residential mortgages. RMBS notes invest in hundreds of millions of dollars worth of home loans based on some of the following:
- The loan duration
- LVR (Loan-to-Value Ratio)
- LMI (Lenders Mortgage Insurance)
- Loan amount
- Region/geography of the security property
These loans are then broken up into smaller classes called 'tranches' that are different sizes based on their category of risk. Each tranche has a different credit rating based on seniority which is determined by rating agencies.
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 0.90% - 1.5% above the BBSW (bank bill swap rate).
- 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. It's this tranche that High Livez generally invests in for yield.
As of September 2019 the current bank bill swap rate is about 1%. Tranche A at 90 basis points above the BBSW would return 1.90% p.a. Deciding to go with a higher or lower tranche depends on the amount of risk you're willing to take.
RMBS vs home loans
Home loans are normally private transactions between a lender and an individual borrower that can stay on a lender's balance sheet for the duration of the mortgage. An RMBS is a debt security that is typically acquired by institutional investors and financial institutions. While home lenders have to pay interest, RMBS investors earn interest.
How does interest work with RMBS?
Interest on RMBS notes is paid in 'coupons' similar to bonds. A coupon is an interest payment promised to the investor at regular intervals for the term of the bond. As a hypothetical, let's say you invested $100 in an RMBS investment with a coupon (you'd need to invest much more than this in reality). If the RMBS investment had a 5.00% p.a. coupon interest rate paying interest every six months, you'd get back $2.50 every six months before getting back the $100 at the end of the loan term.
RMBS notes usually come with monthly coupons that are linked to floating interest rates. Each month, the principal and interest received from the mortgages is paid to investors in the RMBS pool, with the most senior tranches (like Tranche A) paid first.
RMBS transactions pay a fixed margin over the Bank Bill Swap Rate. Banks use this as a benchmark interest rate to measure the cost of their short term funds, and generally, the riskier tranches pay a higher rate than the less risky ones. Here's an example below for a $500 million RMBS transaction.
|Tranche class||Tranche size||LMI||Category||Expected Life||Margin over BBSW this month|
|A||$460 million||Yes||1||3 years||90 basis points|
|AB||$25 million||Yes||2||6 years||180 basis points|
|B||$15 million||Yes||3||6 years||250 basis points|
Pros and cons of investing in RMBS via a managed fund like High Livez
Pros of investing in RMBS
RMBS are issued by many of Australia's banks and non-bank financial institutions, including Firstmac through its High Livez Fund, and are generally considered to be a safer investment than some other asset types. According to rating agency data, no tranche of a prime RMBS has incurred a loss within the last two decades. On top of being lower-risk, RMBS notes also historically give relatively high returns. As you can see in the example above, RMBS can return hundreds of basis points above the BBSW.
Other advantages of investing in RMBS funds include:
- Investing in high-quality assets
- Low or no entry and exit fees
- Relatively low management fees
- Interest paid monthly
- You can quite easily add extra funds to your investment (via High Livez)
See below for more information on how to invest in RMBS.
Risks of investing in RMBS
There are a number of risks when it comes to RMBS:
- They're not easy to invest in: RMBS are mostly available to institutional or 'sophisticated' investors, with only a few exceptions allowing individuals to invest in them
- They can often have very high minimum investment amounts of around $500,000
- The higher-rated tranches have lower returns than riskier tranches
Read on to learn how you can invest in RMBS.
How do you invest in RMBS?
Unfortunately, investing in RMBS isn't as easy as investing in other products like bonds or equities. RMBS are usually only available to institutional or 'sophisticated' investors with very high minimum investments, but there are some exceptions. A notable exception is Firstmac's High Livez Fund, which gives you the opportunity to indirectly invest in RMBS and diversify your portfolio.
High Livez's product is generally suited to investors with a medium-term investment horizon of three to five years. Income distributions are paid monthly and the investment is flexible - you can decide to take the money out at any time at no cost.
You can invest in High Livez with as little as $10,000. To do so, you'll need to fill out an application form and send it back with the required identification, together with cleared funds. You can download this form from our High Livez page, and you'll also need to provide:
- Your account name
- Your BSB
- Your account number
Applications will generally be processed once a month, with units being taken to be issued as at the first business day of each month. You can also make additional investments of at least $1,000.
High Livez is one of the few products on the market allowing everyday investors to invest in RMBS, which should be worth considering as they're generally a safer investment type than some other asset types that still manages to bring decent returns. As said before, no rated tranche of a prime RMBS has ever incurred a loss in the past two decades.