What is RMBS and how does it work?
Residential Mortgage Backed Securities (RMBS) are a specific type of bond that are secured against a large pool of residential mortgages (home loans). Instead of just two or three loans, RMBS notes typically group together hundreds if not thousands of home loans. Lenders put together hundreds of millions (sometimes one billion plus) worth of home loans before breaking them up into 'smaller' classes. These smaller classes are usually still worth hundreds of millions of dollars.
RMBS transactions tend to be issued in two or more separate 'tranches' based on the priority of principal and interest payments. For example, here's what one RMBS pool might look like:
|Tranche name||Tranche size ( $ million)||LMI||Category||Expected Life||Typical Margin|
|A||$450 million||Yes||1||3 years#||1.30%|
|AB||$35 million||Yes||2||5 years#||2.20%|
|B||$15 million||Yes||3||5 years#||4.00%|
# A typical RMBS transaction includes an option for the issuer to buy-back the RMBS at face value once the underlying mortgage pool is repaid down to an agreed percentage (often 10%) of the original pool size. The RMBS note and underlying mortgages have a maximum legal term of up to 30 years. The expected life is determined based on forecast mortgage discharge speeds and issuer buy-back action.
As you can see, the RMBS bond consists of multiple different tranches, which have different credit ratings based on things like risk and seniority. These tranches are determined by independent rating agencies (see below).
- Tranche A (or the first tranche) has the highest rating and consists of about 90% of the total number of loans in the RMBS
- Tranche AB (the second tranche) is slightly riskier than Tranche A and consists of about 5-7% of the number of loans
- Tranche B (the third and final tranche) makes up the remaining 3-5% of the RMBS note
Depending on the issuer of the RMBS, there can be more tranches, but in this instance tranches A and AB are considered less risky than Tranche B, and in the event of defaulting loans, any losses are first allocated to junior tranches. The lower the rating of the tranche, the riskier it tends to be, and the lowest level tranches are typically unrated.
Investors in an RMBS are typically paid the interest and principal from the mortgages in the pool each month, with the principal paid to the most senior tranches first.
The key players in an RMBS transaction
There are usually four key stakeholders in an RMBS transaction:
- The originator: this is the organisation that originates the home loan, such as a bank or credit union. The quality of the loans within the RMBS will be affected by the lending procedures of the originators.
- The trustee: the trustee is primarily responsible for protecting the interests of the security investors.
- The servicer: responsible for managing the loan pool, the servicer calculates the charging of fees, interest and principal, the collection of any payments, performance reporting and more.
- The rating agency: the rating agencies consider the quality and history of the loan pool and prepare detailed analysis about the performance of the RMBS.
Understanding the roles of these key parties is crucial in analysing any RMBS investment.
RMBS risk profile
Whilst all investments involve some degree of risk, RMBS are generally considered to be a safer investment than some other asset types.
According to rating agency data, no rated tranche of a prime RMBS has incurred a loss in the past two decades, while another recent report by Fitch found 99% of ratings on RMBS have been affirmed, upgraded or the notes have been paid in full.
RMBS are issued by some of Australia's largest banks and non-bank financial institutions, including Westpac, ANZ, Commonwealth Bank of Australia, National Australia Bank, AMP, Firstmac and many others.
In Firstmac's High Livez product, most of the loans pooled have an LVR (loan-to-value ratio) of less than 80%, and Lenders Mortgage Insurance on the loans (LMI) provides an additional buffer on the loan security too.
Generally, investments that offer the highest returns tend to carry to highest levels of risk over time. Different types of investments have different risk profiles. The illustration below provides a comparison of risk relative to return.
RMBS falls between cash and fixed income securities as seen above.
What returns do RMBS give compared to other investment options?
The answer to this question will obviously depend on who is issuing the RMBS, but as you can see in the example above, different RMBS tranches offer different returns. A class A-tranche might return a margin of about 1.30-1.50% above the bank bill swap rate (BBSW).
Firstmac's High Livez RMBS product isn't technically a direct RMBS investment, which are usually only available to institutional investors. Instead, it's a unit trust which gives investors the opportunity to pool their money with that of other investors. It's a managed fund which invests indirectly in residential properties.
In the case of High Livez, its eight-year returns have averaged 5.96% p.a. This can be higher than other similar investment classes like bonds or even some riskier ones like equities over the same period and is definitely higher than options like savings accounts and term deposits, which carry less risk and benefit from the government guarantee, but now barely earn over 2.00% p.a in most cases.
The different tranches tend to earn different yields based on the risk level. For example:
- Tranche A might earn about 1.5% above the BBSW
- Tranche AB might earn about 2.5% above the BBSW
- Tranche B might earn about 4.00% above the BBSW
Past performance is not indicative of future performance, and there can generally be quite a few more tranches than what's seen in this example.
How do you invest in RMBS?
Investing in residential RMBS can be a good way to diversify an investment portfolio, but it's not easily done for the average investor. It's often only available at the institutional level and with high minimum investment requirements, but there are some other ways in, aside from directly buying an RMBS.
The main way is by investing in a managed fund that buys RMBS, such as Firstmac's High Livez product. You can simply go online and arrange a call with a Firstmac specialist. The minimum investment in High Livez is a relatively affordable $10,000.