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  • Limitations of RMBS Arrears as an Indicator of Mortgage Stress

    Scott Rundell, Chief Investment Officer | August 2023 Introduction Mortgage arrears have been attracting a fair amount of press lately given the aggressive rise in interest rates and some early signs of ‘mortgage stress’. We believe most of the commentary fails to provide insights on where the risks are, how to avoid them, or what the opportunities might be. While Residential Mortgage Back Securities (RMBS) arrears have risen, we consider this is entirely normal and nothing to be alarmed about vis a vis RMBS investments. Arrears do not equal losses. Two questions. First, is RMBS arrears a good indicator of mortgage stress, and second, what does increasing arrears mean for RMBS performance? Arrears here and now To ensure full transparency, we’ll stick to public data, specifically Standard and Poor’s (S&P) SPIN data. We have also corroborated this with our own data. SPIN data details the proportion of mortgages held within RMBS structures that are behind on their scheduled mortgage payments for 30 days or more. We’ll focus on ‘non-conforming’ mortgages here, mortgages typically written by non-bank originators, such as RedZed, Peppers, Liberty and Resimac. Non-conforming mortgages are to borrowers who do not satisfy the standard lending criteria of mainstream lenders, including banks, for example self-employed borrowers. Non-conforming mortgage arrears are sitting at 3.47% as at the end of June, up from 2.18% a year ago. While arrears have risen vs this time last year, the recent trend has been lower, falling -0.52% in recent months as borrowers adjust to the higher interest rate environment. For some historical context, the long-run average SPIN rate is 8.28% (2000 - now), while the post GFC average is 5.66%. The worst SPIN rate on record was 23.25% in July 2000, while the peak through the ‘GFC’ was 17.09% in January 2009. Even though arrears reached such extreme levels, no rated RMBS tranche incurred an uncured capital charge off. Is arrears data a good measure of mortgage stress? There are no doubt households struggling with their mortgage payments given higher interest rates rising cost of living pressures. But, from the perspective of investing in RMBS, arrears measures are a poor measure of mortgage stress? SPIN only looks at delinquencies within the RMBS universe, which is a small sub-set of the broader mortgage market. In total there are roughly $2.3 trillion of mortgages outstanding nationally – predominantly written by banks. RMBS outstanding on the other hand is down around $90 billion, or less than 5% of total mortgages. Although RMBS is not the worst sample size it is however an incredibly biased and inconsistent one. Loans within an RMBS pool experience a high degree of churn as loans are prepaid at rates of 20% - 30% per annum, moving them out of the RMBS universe and into other funding vehicles, often refinanced by banks. To further complicate matters, outstanding RMBS loans are heavily skewed toward new loans, which are in their early stages (lightly seasoned). This means new RMBS issuances disproportionately influence SPIN, leading to downward pressure on SPIN during periods of high RMBS issuance. Naturally, new loans are less likely to fall behind on payments, with some pools having a weighted-average seasoning as short as six months. Another consideration is the nature of RMBS structures with call factors on RMBS trusts at around 10% - 25% of the original pool balance. In laymen’s terms, each RMBS trust will be brought back by the issuer at some stage, repurchasing the loans and taking them out of the RMBS universe. The call date is set at a certain date generally within 3 - 5 years of issuance, with an additional call-option if the original pool balance reaches 10% - 25% of its original amount. This means as RMBS loan pools season over a 3–5-year period, most loans are refinanced or paid-off prematurely and the remaining loans are subsequently called back by the issuer and vanish from the RMBS universe. Again, another reason why RMBS and SPIN are poor proxies for mortgage stress. Does arrears impact RMBS performance? SPIN is not only a poor proxy of mortgage stress but also a poor measure of RMBS fundamental performance. During the ‘Global Financial Crisis’ or ‘GFC’ (2007 – 2009), RMBS SPIN for non-conforming loans more than tripled, yet no uncured charge-backs were recorded on any rated tranche or note. There was a marked to market impact, given heavy selling on US contagion fears, but actual charge-backs or losses at the time, on rated tranches was zero. Mortgage defaults are relatively uncommon within RMBS pools since they represent unfavorable outcomes for all parties involved, yet they do obviously occur. Lenders are typically cautious about repossessing properties and handle each delinquent loan individually, utilising various measures to rectify the situation. Furthermore, when a loan does default, it is unlikely to result in a loss because the majority of loans in the RMBS universe have loan-to-value ratios (‘LTV’) below 80%. Typically, the weighted-average LTV within an RMBS pool is around ~67% or even lower. In simple terms, this means that if the collateral property is sold, the proceeds from the sale exceed the loan amount, ensuring that the lender is repaid in full. This is the principal advantage of securitised lending. However, even if the collateral does not fully cover the loan, there are additional measures in place to protect RMBS investors from losses. The most significant among these is the presence of ‘excess spread’ within RMBS vehicles. Each month, the RMBS pool collects principal and interest on its loan portfolio, which usually surpasses the principal and interest owed to RMBS note holders. The surplus amount is captured in the structure and can be used to offset any losses incurred by the pool. RMBS trusts often incorporate provisions for accumulating this excess spread in a designated account to prepare for any future losses should they occur. These lock ups / balances can average somewhere between 0.5% and 1.0% of the original pool value. Lastly, RMBS trusts are structured with different tranches, which constitutes senior and mezzanine financing. If losses occur, the charge-back is assigned to the lowest-ranking tranche, typically the unrated note – usually equity, which holds the lowest rank in the waterfall. Tranches can range from AAA rated (the ‘A’ tranche) down to unrated (the ‘G’ tranche). The excess spread from each period can be utilised to address these charge-backs during any subsequent payment month. It is worth noting again that no rated Australian RMBS note has ever experienced an uncured charge-back. There is long run historical data to support the strength of RMBS, or more specifically the economics of mortgage underwriting. Within the banking system, the long run average loss rate on mortgages has averaged 0.02%, since at least 1990. Banks tend to lend to prime borrowers only. Within the non-bank originator space, who cater to the non-conforming borrows, the long run average loss rate is less than 0.10% (originators with 20+ years track record). Now, within your standard RMBS structure, credit enhancements protecting the lowest rated tranche – the ‘F’ note, typically rated single B – total 1.00% - 2.00% on average, sometimes more. Again, no rated note has ever incurred an uncured capital charge back. Why RMBS and Why Now? While the interest rate cycle is likely maturing, there remains a fair degree of uncertainty around where interest rates will go from here. They may linger around prevailing levels (base case) or they could move higher of inflation lingers. This uncertainty underpins fragility in equity market valuations, which despite earnings headwinds remain within throwing distance of their all-time highs. Accordingly, for the more prudent investor, seeking income stability rather than risking capital loss, RMBS funds represent a worthwhile consideration. RMBS structures use floating-rate notes to fund mortgages, meaning they offer a coupon determined as a fixed spread or margin determined at issuance over the one-month bank bill swap rate (1MBBSW). Such structures shield investors from interest duration risk and allows them to benefit from a rising interest rate environment, or a steady income stream during periods of interest rate stability. In the past six months, the credit spread (over the BBSW 1M rate) on RMBS has significantly widened, with notes rated single B, or the ‘F’ tranche, pricing as high as +850 bps. This implies am initial coupon of c.12.5% for note holders. For more risk averse investors, the BBB rated notes, or the D tranches, the spread available is around +450 bps, which provides a coupon of c.8.50%. Mutual Limited is an active investor in the space, with the investment team having over 30 years-experience doing so. Our Mutual High Yield Fund (‘MHYF’) invests down to the B and BB rated tranches generally, with the fund delivering a current gross running yield of over 9.8%, or yield to maturity if 10.2%. Recent cash inflows to the fund have temporarily diluted the running yield. The fund targets a net return over the bank bill index of +4.5%. For 12-month period ending July 31st the fund returned +9.0% vs +3.2% the bank bill index, exceeding its target by +5.9%. Further up the capital stack, we have the Mutual Credit Fund (‘MCF’), which has up to 30% of assets under management in RMBS and ABS. This fund typically targets BBB and BB rated tranches in the RMBS / ABS space and currently is providing a running yield of 7.5%. The fund targets a net return over the bank bill index of 2.2%. Before any RMBS is added to these two funds, and our private mandated clients who appreciate this space, all deals undergo rigorous structural and cash flow stress testing. With regard to the latter, each deal is subject to a doomsday scenario whereby house prices are assumed to fall over 40% in the coming three years, unemployment doubles, the economy contracts by -4.0%, and all defaulting mortgages experience an immediate 15% valuation haircut…among other things. Typically, such an extreme-results in the equity tranche being wiped out, but not the rated tranches, although in some instances there is some very minor charge backs. This is because RMBS pools are structured in such a way to ensure they can survive such extreme downside scenarios. As a sign of Mutual’s analytical rigor, the firm invests in just 17% of the RMBS deals it is presented with. This note is for information purposes only, it does not constitute investment advice. Readers should consider their own personal circumstances before making any investment decisions. Disclosure This information has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347).This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.

  • Chris Judd's Talk Ya Book with Scott Rundell ep: 125

    On the latest Talk Ya Book, Chris Judd welcomes back Scott Rundell from Mutual Limited. Scott shares his thoughts on interest rates and property, US inflation data, and the nuances of how inflation is measured in different markets.

  • Fixed versus floating rate exposure | Is it time to switch?

    The Reserve Bank of Australia (RBA) has hiked interest rates +400 basis points (bps) in the current cycle, taking the cash rate from emergency policy setting of 0.10% in April 2020 to the current rate of 4.10%, the most aggressive rate hike cycle under the prevailing monetary policy setting regime. Over a similar period, Australia’s inflation rate (core CPI) climbed from -0.3% YoY (June-20) to +7.8% YoY (Sept-22), levels not seen since the early 1990’s. The most recent core CPI print was +6.0% YoY (Jun-23). Excluding volatile items, trimmed CPI has eased to +5.9% YoY (Jun-23). While inflation has eased back from 30+ year peaks, the prevailing run rate remains well outside the RBA’s target range of +2.0% - 3.0%. The RBA’s August Statement of Monetary Policy indicated the bank does not expect inflation to be back within target ranges until late 2025, two years away. The trend in inflation is lower, however there remain risks to inflation either re-spiking or lingering at elevated levels longer than expected. Risks to lingering or rising inflation over the foreseeable future include rental and housing costs, which account for approximately 30.0% of CPI and is running at +8.09% YoY. With the threat of increased taxes on rental properties and caps on rental increases, investment is waning, threatening rental supply, which in turn exacerbates the problem. House prices are recovering rapidly and elevated building costs and increased immigration are also contributing to systemic imbalances. Wages growth remains a risk locally also as unions and workers agitate for cost-of-living adjustments threatening a wages-price spiral. Labour markets are showing signs of slack, but also proving to be remarkably resilient with unemployment near multi-generational lows, at 3.7%. The trend is higher, but gradually and still expected to remain well below long run averages (5.6% post the financial crisis). Globally, with the lingering conflict in Ukraine threatening European energy security heading into the Northern Hemisphere winter, gas futures are spiking. We’ve also seen a +21% rise in crude prices over the past 1-2 months. Energy costs are global, impacting transportation costs and manufacturing costs, which would be a headwind also for local inflation. Inflation is easing, but is it easing rapidly enough and is monetary policy restrictive enough to ensure no flare ups, all the while managing a soft landing? So far, apparently yes – but there are risks inflation remains stubborn and lingers above the RBA’s target range for longer than currently expected. Nevertheless, for now the consensus view is that interest rates are either at, or close to their terminal rate (peak cash rate in the cycle). There is some speculation on whether the cycle is done (at 4.10%), or we have one more hike left in the cycle (to 4.35%) – the weight of numbers between these two views is somewhat balanced. There is a less popular, but still plausible view, that there are two more hikes in the pipeline (to 4.60%). Is now the time? Within an investor’s fixed income allocation, is now the time to consider adding duration risk, or is it “too soon?” If so, what are the alternatives? Below we consider the point of indifference between switching from floaters to fixed in a bid to capture duration benefits. We also consider return expectations between various interest rate-based asset alternatives. Namely, RMBS vs Corporate, and investment grade vs sub-investment grade. Fixed Income Alternatives: Pros and Cons For the sake of this exercise, we have assumed a modest-to-high-credit-risk appetite (within the context of fixed income as a defensive asset class) and looked at the following two broad options: 1. Fixed rate credit (duration & credit spread risk) 2. Floating rate credit (credit spread risk) Before looking at each of the above two broad alternatives, some assumptions on interest rates, credit spreads and investment time horizon. We have assumed a one-year investment horizon – anything longer is pie in the sky given uncertainties around inflation and monetary policy settings. For underlying interest rates we have used forward market pricing of the RBA Cash Rate as a proxy for rate movements. Prevailing credit spreads are on or around their long run averages, and expected to range trade over the year ahead. For our best-and-worst-case scenarios we have used +/-25 bps movements relative to the base case through time. 1. Fixed Rate Credit For the sake of this analysis, we have chosen BBB band rated fixed rate securities. The BBB band is the lowest investment grade band within the rating spectrum. For some risk context, over a five-year period, the cumulative default rate for the BBB band is anywhere between 0.90% (BBB+) and 2.63% (BBB-). For BB+, the first sub-investment band on the spectrum is 3.35%. Note, these are ‘corporate’ default rates. We have used the ‘Bloomberg AusBond Credit ‘BBB- to BBB+’ Index (FXD)’ to set the investable universe. The index has 120 individual fixed rate bonds totaling $38bn market value. The weighted average yield of the index is 5.68% (4.55% - 8.02% range) and the weighted average coupon is 3.45% (1.20% - 6.50% range). The index has a weighted average duration of 3.84 years (modified duration). We have not considered private loans, as we do not like their risk dynamics, namely they’re typically unrated and very illiquid (not traded). Over the last 12 months (to the end of July) the mentioned index has returned +3.84% (or +4.17% CYTD). For downside risk, the COVID impact (Mar-20 economic shot down) resulted in spreads doubling, or widening +110 bps, from +108 bps to +213 bps. The marked to market impact from this was -4.50%, the worst monthly loss in the BBB space over the past seven-years. Over the 2022 calendar year the index lost -8.92%, while the financial year ending June 2022 saw a loss of -11.10% as the RBA hiked rates. The index has delivered a negative monthly return 27% of the time since 2013 (i.e 29 months out of 108). Outlook: short of a systemic shock, credit spread stability is assumed over the coming year. Spreads are currently on or around their 5-year averages and expected to range trade. Accordingly, the primary driver of performance will be underlying yields. The outlook for yields is challenging given the inflation back drop and expectations of official cash rates remaining elevated for a prolonged period of time – well into the back half of 2024. Previous interest cycles have seen the gap between the last rate hike and first rate cut average around nine-months, yet the previous cycle saw the gap out to 18 months. Expectations for this cycle are at least 12 months before we see the first rate cut. Expected returns for BBB credit over the year ahead 2. Floating rate credit Comparable securities in the ‘BBB’ band include major bank tier 2, or subordinated debt, which is rated BBB+, and the BBB rated tranche of RMBS structures. The most recently issued major bank tier 2 was from CBA, which priced at +230 bps for a 5Y call and is yielding 6.5%. In the RMBS space, the BBB tranche of non-conforming deals is yielding around 8.5%, or BBSW+450 bps, but with a shorter weighted average life of 3.5 years vs 5.0 years for the above tier 2 line. Despite RMBS being shorter tenor, there is some +260 bps of spread pick up in holding RMBS over major bank tier 2. Why? While each carries similar credit risk, the varied trading dynamics (liquidity), RMBS attracts a liquidity and complexity premium over the tier 2. Tier 2 paper is actively traded, although can go through periods where paper is hard to come by. The best avenue to gain exposure is through primary, but secondary is available for a price. While RMBS is ‘illiquid’ in the broader scheme of things, it is nonetheless traded (unlike private loans) and independently priced. Downside risk during events of market dysfunction is less clean cut, major bank tier 2 is not included in any index, nor are RMBS securities. Accordingly, we have used Mutual’s own funds as proxies, the Mutual Income Fund (‘MIF’) for tier 2 (~60% of FUM) and Mutual High Yield Fund (‘MHYF’) for RMBS (~90% of FUM). At its worst during COVID, MIF lost -2.1% in March 2020, while MHYF lost -2.5%. Losses were recouped within four and six-months respectively. MIF has generated a negative monthly return 12% of the time (2013 – now), i.e. 15 months out of 124. All but 2 of these months were during COVID. Average downside excluding the initial market sell-off was modest at -0.19%. Since inception, MYHF has generated negative return months 11% of the time, i.e. 6 months out of 54, all of which occurred on or around the onset of COVID. Return framework follows, firstly we have the 1Y return matrix for major bank tier 2 given various BBSW and spread change scenarios. * Assumes changes move over 6-month and 3MBBSW reverts to historical average after two years. ** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns. BBB major bank tier 2 paper vs BBB fixed rate corporate? Pros and cons? Liquidity first - major bank tier 2 is arguably more liquid than BBB fixed rate corporate paper, with banks ‘generally’ supporting their own paper during periods of market dysfunction. Duration of the fixed rate bonds is attractive on the surface, ‘if’ we are in fact at the end of the hiking cycle. Such is not a given. The risk of getting duration wrong can be meaningful. Fixed rate credit return volatility (monthly) is historically 3 – 4 times more volatile than floating rate credit returns. With expected returns on BBB fixed corporate credit around 6.00% - 6.25% versus similar returns for major bank tier 2 (rated BBB+), an investor should be indifferent between the two on a return only basis. However, if we adjust for risk, tier 2 paper is a better alternative. Tier 2 relative value is also attractive, per the following, offering a more attractive spread than the bulk of the BBB index. Source: Bloomberg, Mutual Limited Switching to RMBS. RMBS spreads are at their pre-and-post pandemic wides, and likely long run historical wides also. Looking down the capital stack, the spread on offer for ‘AAA’ rated tranches is around +170 – 190 bps, offering a yield / coupon around 5.70% - 5.90%. ‘AA’ rated tranches offer +300 – 350 bps or 7.00% - 7.50%, ‘A’ rate tranches 400 – 425 bps or 8.00% - 8.25%, ‘BBB’ rated trances offer +450 – 475 bps or 8.50% - 8.75%, while the sub investment grade tranches offer +750 – 900 bps, or 11.50% - 13.00%. Spreads have widened in the past 6 months on arrears concern and risk of falling house prices. The latter have stabilized and risen off their recent troughs, with consensus forecasts pointing to +5.00% - 7.00% growth over the coming year. Market technical – supply and demand dynamics – remain favourable for continued price stability. Arrears have risen as the RBA has hiked rates – which is to be expected - however in the past 2 – 3 months, arrears have stabilized and actually reversed course as households adjust to the higher rate settings. Low unemployment has also contributed to arrears strength, which remains well below long run averages. The following table displays return possibilities for ‘BB’ rated RMBS given changes to 1MBBSW and traded margins. Data: Bloomberg, Mutual Limited * Assumes changes move over 6-month and 1MBBSW reverts to historical average after two years. ** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns. Given the return outlook for both major bank tier 2 and RMBS, the following table displays return possibilities for the Mutual High Yield Fund given differing BBSW and spread scenarios. Data: Bloomberg, Mutual Limited Assumes changes move over 6-month and 1MBBSW reverts to historical average after two years. ** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns. Note, an important characteristic of RMBS vs say tier 2 is that after a period of time, typically somewhere between 6 – 12 months, RMBS tranches begin to amortise. This reduces risk and generally, within 18 months of issuance (historical average), results in the tranches being upgraded by the rating agencies. Lastly, no rated RMBS tranches has ever incurred an uncured capital loss. Further, the underlying loss rate from mortgage lending across the non-bank lending sector has averaged less than 0.10% since inception. In conclusion Starting with a question, is now the time to add duration risk over say floating rate credit? In short, we think there is time to make that call. Whether we’ve reached the peak of the interest rate cycle is still a matter of debate. Yes, we’re near the top, but there is the risk rates will go higher. The market view is that interest rates will stay elevated and flat over the year ahead. Perhaps decline marginally toward the end of next year, as indicated in the first of the following two charts. Within this environment capital gains would not represent a significant contributor to overall returns, with carry (or coupons) likely to be the core return contributor. The risk to this view is if the economy slows more rapidly than currently expected and we see a meaningful spike in unemployment. Such would likely trigger a dovish turn in monetary policy settings, resulting in a fall in yields (capital gains). Not the consensus view, but a scenario that can’t be entirely discounted. Still, an unlikely turn of events. Alternatively, we witness lingering inflation with further rate hikes deemed necessary. In this environment, floating rate securities offer relative immunity to duration risk, protecting capital, while still delivering income to support total returns. Market Terminal Rate Pricing Data: Bloomberg, Mutual Limited The first rate cut from the RBA is not realistically priced in until the back end of 2024, possible early 2025. Since 2000, underlying yields (ACGB’s) have traded at a margin to the cash rate of +11 bps for 3Y ACGB’s and +60 bps for 10Y ACGB’s. Assuming mean reversion here, the prospect of capital gains from falling yields over the year ahead is low to modest. ACGB Bond Yields vs RBA Cash & CPI Data: Bloomberg, Mutual Limited

  • A Beginner's Guide to Residential Mortgage Backed Securities

    Mutual Limited manages $2.6 billion on behalf of investors across four retail funds and a range of individual wholesale mandates. The firm’s core focus is debt or credit securities that have contractual payment profiles. These securities include principally floating rate notes (FRNs), which are a debt obligation like a typical bond used by banks to fund their lending activities to mainly households or small businesses. FRNs represent a contractual requirement for the banks to pay the coupon when they fall due as well as the balance at maturity. Senior rated major bank FRN’s provide investors with a prevailing yield of 5.2% - 5.3% for a 5-year maturing note (as at the time of this report). Subordinated notes, which rank below senior notes, offer yields of 6.3% - 6.4% for a similar maturity. An alternative FRN asset class that isn’t as well known by retail investors is Residential Mortgage Backed Securities or ‘RMBS’, which are structured vehicles used by banks and non-bank lenders to help fund their mortgage lending activities. The market for RMBS is meaningful, with $22 billion issued year to date and annual issuance over the past five-years around $43 – $49 billion per annum. Through its funds and on behalf of its clients, Mutual Limited holds close to $250 million in RMBS. A ‘BBB’ rated RMBS note is currently offering yields of 8.8% - 9.0%. In this piece we answer frequently asked questions investors often have with regard to RMBS. What are RMBS (Residential Mortgage-Backed Securities)? Securitisation is the process of converting a pool of cash flows, i.e. mortgages, into tradable securities, in this instance, Residential Mortgage Backed Securities, or RMBS. The RMBS securitisation process involves a mortgage originator, such as a bank or non-bank lender, selling a pool of loans into a special purpose vehicle (aka SPV). In turn, the SPV issues debt securities (‘RMBS’) to investors (such as Mutual Limited) to fund the purchase of these loans. The SPV has no other purpose. The interest and principal from the underlying mortgages loans are used to pay interest and repay principal on the underlying securities, or the RMBS. What types of loans are used in securitized structures? Securitisation is most commonly used with home loans – at least in a volume sense, which is what RMBS are populated with. ABS, or Asset Backed Securities, are structures backed by loans to fund cars, trucks, office equipment, business receivables and even solar panels to name a few. Lastly there is CMBS or Commercial Mortgage-Backed Securities, which are populated with loans to fund commercial property purchases. In 2022, annual volume of RMBS issuance was $35.1 billion, while ABS accounted for $6.2 billion and CMBS $1.5 billion. What is mezzanine financing and how do tranches work? A typical RMBS structure ranges from $500 million to $1 billion in size, with average loan size around $250,000 - $450,000. Each RMBS structure is divided up into 6 or 7 ‘tranches’, sometimes as many as 10. 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. RMBS structures are rated by rating agency firms such as S&P, Moody's and Fitch, with each tranche allocated a rating based on its position in the capital stack, and layers of support below it. Investors with a lower risk appetite might focus on Class A tranches, which are usually rated ‘AAA’ and represents circa 80% - 85% of the structure by dollar value (proportion varies depending on quality of underlying loans). At the time of writing, ‘AAA’ rated RMBS are offering yields of ~5.7% - 5.9%, or +160 – 180 basis points above the prevailing cash rate. On the other hand, an investor with higher risk appetite might invest in the Class D tranche, which is typically rated 'BBB', and offering yields of ~8.5% - 9.0% at the time of writing (+440 – 490 basis points above cash). Higher tranches earn less interest income but they're more insulated from the risk of default of the underlying mortgages. Any losses from defaulted mortgages are absorbed firstly by equity in the structure and then lower ranked tranches, moving up the tranches if and when defaults intensify. Anything below Class A is typically referred to as a “mezzanine” tranche. The following is a simplified schematic depicting a typical RMBS structure. What are the main risks associated with RMBS? Very broadly there are two core risks that determine the underlying fundamental strength of RMBS, and in turn performance as an investment. The first is default risk, whereby one or more of the underlying mortgages default because of non-payment of the loan interest and principal as and when due. The second is loss given default, that is once a borrower has defaulted and the secured property is sold, there remains a shortfall relative to the outstanding loan balance. What are the historical default rates and performance of RMBS? For the sake of this question, default rates refer to default of the rated tranches in the structure, and not the underlying mortgages. And, to answer the question, zero. In the 25+ years that RMBS has been used as a funding source, the number and percentage of rated tranches that have default is close enough to zero to be zero. Put another way, no rated tranche has ever incurred an uncured capital loss. Performance is difficult to quantify given the evolution of RMBS structures post the global financial crisis and lack of publicly available data. There is no RMBS index. How liquid is RMBS investments? Like government bonds or vanilla bank bonds, RMBS are over the counter securities. Under normal trading conditions, most major banks make markets in ‘AAA’ rated RMBS tranches, in that they will buy such paper onto their books / balance sheets and on sell it to other investors as and when opportunities arise. Anything rated ‘AA’ and below is typically traded on a best endeavours basis, i.e. banks will try and find buyers if you’re a seller and so on. In Australia there are approximately $2.2 trillion of outstanding residential mortgages, written by banks and non-banks, across both investor and owner-occupied borrowers. Of this volume, around 5% -10% is funded through RMBS. Year to date, RMBS issuance has totalled $15 billion versus last year’s full year issuance of $35 billion. Average annual issuance over the past ten-years has been $20 - $25 billion per annum, a meaningful number. If we apply a standard 80% - 85% AAA rated tranche ratio to these figures, that suggests AAA rated tranches total $16 - $20 billion. During periods of meaningful market dysfunction, the RBA and AOFM have actively supported RMBS market liquidity. The RBA recognises that RMBS markets are a core element of credit creation, particularly for borrowers who traditionally do not meet normal eligibility requirements of the mainstream lenders (ie. banks). What are the costs and fees associated with investing in RMBS? There are no direct costs or fees to investing in RMBS. However, retail investors are typically unable to invest directly in RMBS as it is generally an institutional investor market with minimum traded parcel size of $500,000. Accordingly, for investors to gain access to the asset class they need to go through a professionally managed fund. Such funds typically charge a fee. Mutual Limited offers two funds that invest in RMBS, including the Mutual Credit Fund, which is permitted to hold up to 30% of assets under management in RMBS or ABS securities. This fund targets returns of the bank bill swap rate +2.20% net of fees. The fee on this fund is 0.48%, or $48 per $10,000 invested. The fund has no exit or entry fees and does not charge performance fees. As at the date of this paper, the fund is yielding 7.50%. The other fund is the Mutual High Yield Fund, which can invest up to 100% in RMBS or ABS, this fund targets a higher return of the bank bill swap rate +420 bps net of fees. As at the date of this paper the fund was yielding 10.31%. As with the Mutual Credit Fund, the High Yield Fund has no performance fee, no entry free, but a modest 0.25% exit fee. Are there any regulations specific to RMBS? Non-bank originators or lenders are not regulated by the same authorities as banks, i.e. APRA, however they voluntarily adhere to APRA’s minimum underwriting standards. Lenders are required to be licensed under the National Consumer Credit Protection Regulations 2010, with licensee’s obligation to meet minimum ongoing requirements in order to continue lending. With regard the RMBS structures, specifically their legal form, they are covered under the Corporations Act 2001. What happens if borrowers’ default on their mortgages? If a borrower defaults on their mortgage, and assuming the documented cure process is adhered to, and assuming there is no likelihood the borrower could continue to service the loan, the underlying property is repossessed and sold. Proceeds are used to repay the loan with capital returned to the RMBS structure. If there is any shortfall, the lender would look toward the borrower’s other assets to recoup any losses. What happens if housing prices decline? RMBS structures typically have a weighted average loan to value ratio of 65% - 70%, with some mortgages as high as 90% and others as low as 40%, for example. Most investors will avoid any structure with more than 10% of mortgages with LVR’s greater than 80%, accordingly such structures are rare. Nevertheless, all mortgages are added to the pool with positive equity when originally underwritten (or lent). Once an RMBS is launched, the underlying collateral – properties – will move in value according to market forces. Declining property prices only become a problem if and when a mortgage is foreclosed upon and sold at a price below the outstanding loan amount. If this occurs, the RMBS structure incurs a capital loss, which is initially covered by any excess spread reserves (credit enhancements) and after that any losses are charged off against the equity tranche. Using the example structure above, this deal had an equity tranche of $16 million and another 0.5% - 1.0% of credit enhancements below the equity tranche. Accordingly, there is $21 - $26 million of loss absorption protection below the first rated tranche, the Class F notes (rated ‘B’). This loss piece is not utilised unless the fall in house price is greater than the borrower’s equity built up in the property. With regard to this example, the structure in question had a weighted LVR of 64%, 2,000 mortgages and average loan balance of $484,000. So, at the average, the structure could withstand a 36% decline in house prices and assuming the average mortgage defaulted, none of the rated notes would incur a capital loss. Historically, since the recession of the early 1990’s, the worst peak to trough decline in house prices has been 10.0%. Is Australian RMBS similar to offshore securitized products (i.e., in the US) Australian mortgages are materially different to US mortgages. The two main differences are loan recourse and tax treatment. Another consideration is the strength and stability of the Australian banking and non-bank lending market versus the US, a core difference, at the bank level at least, is the strength and quality of regulatory oversight. Loan Recourse: US mortgages are generally non-recourse loans. Australian mortgages on the other hand are full-recourse. Australian mortgages include a personal guarantee from the borrower, which allows banks and lenders to a borrower’s other assets in order to pay any mortgage balance outstanding post foreclosure and sale of the property. A US mortgages typically do not include personal guarantees and as such lender do not have the same avenues available to then to recoup any losses. Tax Treatment: interest on US mortgages is tax deductible, yet any capital gain made on the sale of the property is taxed – for both investment property and prime residence. This incentivises borrowers to keep their loan to value ratio (LVR) high. In Australia, mortgages on a borrower’s primary residences are not tax deductible and any capital gains made on the sale of the property is tax free. Therefore, Australians are incentivised to reduce their LVR’s as quickly and as much as possible. Are RMBS investments safe? As with any investment, there are risks to investing in RMBS. As per previous questions and answers in this piece, no RMBS structure has ever incurred an uncured capital loss. However, that is not to say haven’t incurred losses. As with any traded security, underlying price can and does vary. Under normal trading conditions, RMBS securities can be expected to trade around $97.5 -$102.50 up and down the capital stack, with par and issue price being $100.00. However, there have been periods of market ‘dysfunction’, such as the global financial crisis or COVID pandemic. This can impact pricing. Example: at the height of the global financial crisis local RMBS investors sought to sell their RMBS positions on fear of contagion from US markets (where RMBS structures were defaulting as inflated house prices plunged). Now, while Australian mortgages differ materially from US mortgages, investors still panicked. Consequently, there were more sellers than buyers. At the time, around late 2008, early 2009, I observed AAA rated RMBS tranches trading at $60.00, or 60 cents in the dollar vs an issue price of $100.00. The underlying pool of mortgages was performing to expectations, with arrears manageable and none of the rated tranches at loss of loss. Shortly after, as the RMBS structure amortised, these securities repaid at par, $100.00. Coming back to the original question, we would highlight that historically no rated RMBS tranche within the Australian dollar RMBS market has ever defaulted. This includes during the global financial crisis, the European sovereign crisis and more recently the COVID pandemic and resulting economic shut-down. How are RMBS investments rated? Most RMBS notes are assigned ratings by one or more ratings agencies (S&P, Moody’s or Fitch). The rating agency will stress test the overall pool of loans and assign a rating to each RMBS tranche. Higher RMBS tranches are designed to withstand more severe economic environments than lower rated tranches. Under S&P’s RMBS rating methodology, AAA-rated RMBS tranches are stress-tested to withstand a great depression like scenario. Importantly, all noteholders within an RMBS trust share the same pool of loans despite being in different tranches within the mezzanine structure. The ranking of higher tranches and lower tranches is only relevant when distributing the aggregate income, principal or losses from the pool of loans at each payment period – all loans are shared by all noteholders and all tranches. What is a non-conforming loan? Broadly speaking there are two types of mortgages or loans used to populate RMBS structures. “Prime” loans and “Non-Conforming” loans. The Reserve Bank of Australia defines the two as follows…”Prime mortgage loans are those made by mainstream mortgage lenders (banks and other deposit-taking institutions and mortgage originators). Non-conforming mortgage loans are those made to borrowers who do not meet the normal eligibility requirements of the mainstream lenders.” An example of a non-conforming borrower is someone who may be self-employed with an irregular income stream, i.e. tradesman, doctors, dentists etc. Non-conforming borrowers could also be borrowers with a few dents in their credit record.

  • The US debt ceiling: a dangerous anachronism

    Readers of the financial press recently will have noted the term “US debt ceiling” popping up frequently in the market narrative. It is one of those potential events in markets where there is a very, very small probability of a really bad thing happening, but if it does, oh Lordy, step back and fear the market’s wrath! To assist with setting the tone, the following is from the US political drama series, “The West Wing”, a junior staffer asks: “so this debt ceiling thing is routine, or the end of the world?” White House press secretary Toby Ziegler replies: “Both.” What is the US debt ceiling? The US debt ceiling is a legislative limit on the amount of national debt that can be incurred by the US Treasury. It was first created in 1917, and is arguably outdated and similar limits are very rare amongst peer nations. The current limit is set at US$31 trillion, triple what it was after the financial crisis in 2009. Because the US Federal Government runs budget deficits - meaning it spends more than it brings in through taxes and other revenue - it must borrow sums of money to pay the bills. These debt obligations include funding for social security programs, interest on the national debt and salaries for government employees. The US Treasury reached the ceiling in January 2023 and has had to take extraordinary measures to manage the books. These measures are expected to be exhausted by June 1st. When the US Treasury spends the maximum amount authorized under the ceiling, Congress must vote to suspend or raise the limit on borrowing. While Congressional leaders in both parties have publicly recognized increasing or suspending the limit is necessary, congressional brinkmanship over the issue in modern times has increasingly led to disruption, including government shutdowns, and the spectre of default that has threatened to push the US economy into crisis. Since 1960 Congress has acted 78 times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. So, there is form here, increasing the limit, although the 77th and 78th times, in 2011 and 2013 respectively, did not come without a struggle. Politicking took the debate in these two instances right down to the line, and the political circumstances haven’t improved. What happens if the limit isn’t increased or suspended? The US government would declare it can no longer pay its debts, and effectively default, an outcome that is historically inconceivable. Predictions on such a turn of events vary in their severity, all of which are grim. Moody’s stated should the US default on its debt “GDP would fall by close to 4%, six million jobs could be lost, mortgage and business interest rates would spike, and US$15 trillion would be wiped off the value of assets markets.” US Treasury Secretary Janet Yellen has described this sequence of events as “catastrophic…and…failure to meet the government’s obligations would cause irreparable harm to the U.S. economy, the livelihoods of all Americans and global financial stability.” What are the broader ramifications of a US government default? Such an eventuality would wreak havoc on global markets, likely dwarfing the financial crisis triggered by the Lehman Brothers collapse. The creditworthiness of US treasuries has long supported demand for US dollars, contributing to their value and prevailing status as the world’s reserve currency – around 60% of the world’s foreign currency reserves are held in US dollars. Accordingly, any hit to confidence in the US economy, whether from actual default or the rising uncertainty surrounding its potential, could cause investors to abandon US treasuries (yields spike higher) and thus weaken the US dollar. US assets in general would come under immense selling pressure. What is priced into markets here and now? Before going into any detail, it is worth noting that historically there have only really been two periods where an agreement to increase the debt ceiling has gone right down to the wire. Accordingly, lessons from the past are scratchy. Starting with stocks in general, and the S&P 500 in particular, the index is up +6.1% since the debt ceiling was reached (the ASX 200 is off, -3.0%). At face value stock markets are ignoring the situation. Arguably, other global events have occupied investor’s attention, namely inflation, monetary policy, credit crunches and recession risk and then toward the end of Q1, US regional bank failures. Stock market volatility has been elevated through this period, but nothing more than what we have observed in the past year or two. While the debt ceiling is gaining real estate in the broader narrative, its impact on markets has been muted thus far. What about bond markets? Similar to stocks in that other factors are likely influencing sentiment and trends, again it is inflation, recession risk and monetary policy settings as the unholy trinity right now. No signs of concern in bonds either. Although, toward the very front of the curve we’re seeing signs of concern. Yields on short-term money-market instruments such as 1mth, 2mth and 3mth T-bills have already shot up over the past few weeks on concern that the X-date — when the Treasury will have exhausted all its special accounting manoeuvres — is drawing closer. For instance, 1mth T-bills have seen their yields surge more than 100 bps this month alone to a cyclical peak of 5.46% (since back at 5.20%). Credit markets, or specifically Credit Default Swaps, or CDS markets appear to be most sensitive to the situation. At the beginning of the year, US Government one-year CDS premiums were trading at 15 bps, which reflects default probability of approximately 0.25%. CDS spiked to 77 bps with the debt ceiling being reached, and then spiked again mid-April to 176 bps as the urgency of messaging from the US treasury grew. Default probability is now at 3.0%. For comparison, Australia’s sovereign CDS is steady at 21 bps, albeit up from 17 bps at the beginning of the year. Cash credit spreads have been more focused on primary activity, which I expect will continue. Back in the day, during the 2011 experience, we observed no meaningful weakness in cash spreads. During the 2011 impasse, spreads reached a peak of about 80 bps, and during the 2013 re-run, the market reaction was similar, with the spread touching about 78 bps. Stocks during the 2011 impasse showed similar apathy to the matter that we’re now experiencing, right up until the death nell. The date at which treasury would run dry was July 31st, 2011. Two weeks before this date, the S&P 500 was up +7.0% YTD, and then with no progress in debt ceiling discussions, the S&P 500 proceeded to fall -17.0% in three weeks. Eventually an agreement of sorts was met and stocks rallied into year-end, +14.4% from their intra-year lows. There was some collateral damage though, the government was downgraded from AAA to AA+ just days after agreeing to increase the debt ceiling. Still in 2011, as the July 31st deadline approached, bond yields plummeted, both in US and AU, in fact more so in the latter. US 2Y treasury yields fell -26 bps in the week leading up to the deadline, while ACGB 3Y yields fell -81 bps. The cyclical trend in yields was lower, so the debt impasse just accelerated the move – note, official cash rates were unchanged through these events, but two rate cuts came in the latter quarter of 2011. Yields ended the year lower again. In the case of US treasuries, a perverse reaction given growing risk that theoretically these were the instruments potentially defaulting and as such did occur, the consensus view is investors would abandon US treasuries if they defaulted. Going forward If the debt ceiling goes down to the wire, the closer we get to said wire, the more volatility we’re likely to see. If it plays out like 2011, equities will come under selling pressure toward the back half of May (assuming no agreement to increase the ceiling before-hand), while bonds will see yields decrease (price higher), as crazy as that sounds. Cash credit spreads should prove resilient, and at worst range trade. Synthetics will be volatile, moving in step with any equity market volatility. All told, the surge in CDS pricing and money-market bills shows investors aren’t willing to assume that common sense will prevail at the end of the day. But, should the worst happen and the US defaults, it will likely be cured in quick order once the politicians recognise the error of their ways. Unfortunately, the degradation of US prestige from their actions will likely linger. Note…. for some local context, Australia did have a debt ceiling, introduced in 2008-2009 in response to the financial crisis. Thankfully, it was short lived with the ceiling abandoned almost 10 years ago. [1] A CDS is financial derivative that allows an investor to swap or offset their credit risk with that of another investor. Investors can buy credit risk synthetically, or sell it. If an investor has concerns about the underlying credit quality of an issuer, they can buy a CDS that essentially protects them in the event of default.

  • Mutual Limited bolsters team with new investment analyst

    Melbourne – 3 July 2023, Mutual Limited, a credit and fixed income fund manager based in Melbourne, today announced the appointment of Alan Au as Investment Analyst. Alan will undertake research and analysis of credit securities and will report to Mutual Limited Chief Investment Officer Scott Rundell. Alan has experience across private markets, wealth management and asset consulting. His most recent position was investment analyst at Atchison, prior to that he was an analyst within the capital market division at Escala Partners. Mr Rundell said, “We are pleased to welcome Alan to the Mutual Limited team. His technical expertise and experience will be critical for our active management approach, particularly as we are seeing increased investor demand for defensive allocations in portfolios.” Alan has a Master of Commerce from Deakin University majoring in Accounting and Finance and a Bachelor of Medical Radiations in RMIT University. Alan is currently a level II CFA Candidate. The latest appointment builds on the recent announcement that the Mutual Wholesale Income strategy has been added to FirstChoice’s Investment and Super & Pension platform menus. The strategy gains exposure to the Mutual Income Fund, which seeks to provide a reliable income for investors and a high level of capital preservation by investing in a portfolio of Australian bank senior and subordinated floating rate notes, with a concentration to the Big four banks. The Mutual Income Fund celebrated its 10-year anniversary in April 2023 and has returned 2.52% p.a.net of fees since inception to May 2023, exceeding the Bloomberg AusBond Bank Bill Index return of 1.71% p.a. The Fund’s current yield to maturity is 5.48%* before fees, and its performance has been bolstered by successive interest rate hikes. Mutual Limited is an Australian-owned cash, credit and fixed income investment manager with $2.6 billion under management. Its four funds are distributed by Copia Investment Partners. * 5.48% running yield is gross of fees as at 26 June 2023 This information has been prepared by Copia Investment Partners Limited (AFSL 229316 , ABN 22 092 872 056) and Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347), the Responsible Entity and issuer of the Mutual Cash Fund, Mutual Income Fund, Mutual Credit Fund and Mutual High Yield Fund. This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions. © 2022 Copia Investment Partners Ltd.

  • Mutual Limited Income option added to FirstChoice Platform

    Mutual Limited today announced that the Mutual Wholesale Income strategy has been added to FirstChoice’s Investment and Super & Pension platform menus effective 22 May 2023. The strategy gains exposure to the Mutual Income Fund, which seeks to provide a reliable income stream and a high level of capital preservation by investing in a portfolio of Australian bank senior and subordinated floating rate notes, with a concentration to the Big 4 banks. The Fund is designed to provide retail investors with exposure to Australian Bank bonds to provide better-than-cash returns with limited interest rate volatility. The Fund’s current yield to maturity is 5.43%1 before fees, and its performance has been bolstered by successive interest rate hikes. Wayne Buckingham, Managing Director of Mutual Limited said “We are excited to be engaged by one of Australia’s leading wealth management groups providing investment, superannuation and retirement products to individuals, corporate and superannuation fund investors. The Mutual Wholesale Income option offers platform users an income-focused, cost-effective and well-rated solution that only invests in Australian banks.” The Mutual Income Fund celebrated its 10-year anniversary in April 2023 and has returned 2.51% p.a.net of fees since inception, exceeding the Bloomberg AusBond Bank Bill Index return of 1.69% p.a. Mutual Limited is an Australian-owned cash, credit and fixed income investment manager with $2.7 billion under management. Its four funds are distributed by Copia Investment Partners. 1 5.43% running yield is gross of fees as at 29 May 2023) - ENDS – Media contact Amy Boyce amy@abcpr.com.au 0449 553 990 Disclaimer: This information has been prepared by Copia Investment Partners Limited (AFSL 229316 , ABN 22 092 872 056) and Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347). Mutual is the Responsible Entity and issuer of the Mutual Cash Fund, Mutual Income Fund, Mutual Credit Fund and Mutual High Yield Fund. This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, Mutual, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia and Mutual are not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions. © 2022 Copia Investment Partners Ltd.

  • Video: Is this the last rate rise?

    Mutual Limited CIO Scott Rundell discusses why the RBA hiked unexpectedly and what’s changed in their thinking. Scott also provides his view on whether more rate rises are coming.

  • Chris Judd's Talk Ya Book with Scott Rundell

    On the latest Talk Ya Book, Chris Judd welcomes back Scott Rundell from Mutual Limited. Scott discusses the state of the banking system amid the recent turmoil, why the gold price has been moving strongly in an upward trajectory and whether the US Dollar can remain a global reserve currency.

  • Mutual Observations: Silicon Valley Bank & Credit Suisse Post Mortem

    Background The past week or so has been wild for global markets with some very wide trading ranges across bonds, stocks and hybrid securities, aka AT1. Offshore credit markets have also been volatile, and while we have seen some widening in local A$ credit, the moves have been relatively muted by comparison. The collapse of Silicon Valley Bank (‘SVB’) in the US and contagion effects represents ground zero for this saga and story of woe. While regulatory action was taken to stem the blood-letting, confidence on whether these actions were enough waivered from day-to-day. Eventually it appears all was good in the hood, but then more recent comments from US Treasury Secretary Yellen poo-pooing expansion of current depositor support programs have added to inter-day volatility. This will likely remain a moving feast for days, probably weeks, to come. Adding to the sense of impending market doom, early last week, the lights almost went out on Credit Suisse. After more than 160-years in business, the Swiss bank faced its own crisis of confidence, with visions of Lehman Brothers coming back to haunt markets. After a few days of angst and anxiety, the Swiss National Bank brokered a deal for UBS to acquire Credit Suisse. As part of the deal, however, a meaningful wedge of Credit Suisse AT1 capital was wiped out. Against the natural order of capital, Credit Suisse equity survived. Heads were scratched. With the risk of new financial crisis waning, I thought it constructive to conduct a brief post-mortem of recent events. Now, ‘Post mortem’, ‘noun: an examination of a dead body to determine cause of death.’ After last night’s comments from Yellen, one could suggest said body has a pulse. Nevertheless, I expect the worst is behind us and we’re seeing some involuntary death spasms… if that is in fact a thing. In the following piece I provide a review of Australian bank liquidity, and why we’re ‘different’ to US banks. I also look at the Credit Suisse situation, and why Australian bank AT1 capital, and Tier 2 capital for that matter is sound. Lastly, some commentary around how local bond and credit markets have performed of late. Before I proceed, a shout out and a gentlemanly tip of the cap to Brendon “Coop” Cooper at WBC who has published two very informative pieces on bank liquidity and AT1 dynamics recently. Some might be tempted to call my “borrowing” of his words as “blatant plagiarism”, however I prefer to term it as “para-phrasing with respect.” And, besides, plagiarism is the sincerest form of flattery. Australian Bank Liquidity Concern for Australian bank liquidity, particularly the regionals, stemmed from the situation that engulfed Silicon Valley Bank. Contagion risk, unfortunately saw other smaller US regional banks hit with deposit runs. SVB’s issues were not caused by any systemic shock, although the genesis of their downfall was rooted in the pandemic and monetary policy responses. The main cause was risk management incompetence – both at the bank level, but also within the US regulatory framework. To recap, through an absence of interest rate risk management, SVB left its balance sheet exposed to rising interest rates. A defence of SVB’s failings here, as weak as it is, is the fact they were not required by regulators to hedge interest rate risk. Under the Trump Presidency, regulatory hurdles for banks were loosened. As a consequence, SVB had no requirement to meet Liquidity Coverage Ratio (‘LCR’) or Net Stable Funding Ratio (‘NSFR’) minimums. Looking further afield, less than 10% of US banks (by total assets) are required to meet minimum ratio requirements in this regard. Australian banks on the other hand… “Australian liquidity rules (APS 210) apply to all ADIs through either the Liquidity Coverage Ratio (LCR) for large banks or the Minimum Liquidity Holdings (MLH) rules for smaller banks. The minimum requirement under the LCR is 100% (HQLA/net cash outflows), however all LCR banks are currently well above 120%, while MLH banks are required to hold liquid assets in excess of 9% of total assets. It should also be noted that the bulk of deposits at domestic MLH institutions are retail (i.e. sticky) providing a strong starting base in liquidity terms.” (WBC). Liquidity requirements for US banks are applied according to the size of the bank. Only banks with asset bases >US$750bn are required to meet the kind of LCR requirements that all Australian banks are required to meet. SVB was ranked 18th by total assets, but accounted for <1% of system assets. Regulatory wise, it slipped under certain minimums for wholesale funding, and were not subject to LCR or NSFR requirements. Australian banks on the other hand must hold minimum HQLA, or “High Quality Liquid Assets”, in order to meet minimum LCR’s. Australian banks are subject to one of the most conservative interpretations of the LCR regulatory requirement. They can only hold cash, ACGB’s and Semi’s as HQLA’s, and at the moment cash is elevated, which is evidenced by elevated ES balances – i.e., very liquid. US banks on the other hand have a broader range of assets they can hold for liquidity purposes, including investment grade credit or equity for some banks….and only for those banks big enough to fall within the regulators net. SVB was undone by the lack of interest rate hedging, which is not standard practice (not having it that is) and underpins my earlier accusations of gross incompetence. One key difference in capital requirementsbetween Australian and other jurisdictions, including the US, is the treatment of interest rate risk hedging. “Australian regulators have included IRRBB as a Pillar 1 requirement, with a capital charge reflecting risk. In other jurisdictions this risk is largely a Pillar 3 disclosure requirements, with the potential for a supervisory add-on to capital if required by the regulator. As a result, domestic banks offer strong disclosure, active risk management and a capital charge in place for this risk.” (WBC). In addition to LCR requirements, Australian banks are required to maintain contingent liquidity in the form of self-securitised assets, with a cash value equivalent to at least 30% (onto the LCR). The collateral needs to be needs to be unencumbered, and not held as collateral for any other purpose. So, no liquidity issues here. Not all AT1 is created equal…some are more equal than others UBS acquired Credit Suisse for CHF3bn (US$3.3bn) at the insistence of the Swiss National Bank. Credit Suisse equity holders received UBS stock in return, albeit at a deeply discounted price. Credit Suisse’ “alternative tier 1” capital was wiped out. Swiss authorities said those security holders would receive absolutely nothing, a move that is at odds with the usual hierarchy of losses when a bank fails, with shareholders typically the last in line for any kind of payout. Heads were being scratched. As a result of this very surprising, some might say, shocking turn of events, central banks and regulators around the world, including the BOE and ECB, released statements saying that common equity will be the first to absorb losses, and only after this will AT1 and Tier 2 securities incur potential losses in a non-viability situation. Where does that leave A$ AT1? Local AT1 securities have worn some pain as holders shoot first (sell) and ask questions later. Looking at the non-viability and credit hierarchy, under APRA guidelines the definition of non-viability is broad, effectively being triggered when APRA decides either i) conversion or write-off of capital instruments is necessary because, without it, the ADI would become non-viable; or, ii) without a public sector injection of capital, or equivalent support, the ADI would become non-viable. Conversion….”AT1 and Tier 2 instruments must contain a provision that requires the conversion to equity in a non-viability event, resulting in the dilution of equity holders. Write-off will only occur where conversion to equity is not possible (this includes some unlisted issuers). Australian instruments also allow for partial conversion, which was not possible in the case of CS.” (WBC) Importantly for tier 2 investors also, ranking rules dictate that APRA… “must provide for all AT1 capital instruments to be fully converted or written-off before any Tier 2 instruments are required to be converted or written-off. Any conversion or write-off of Tier 2 instruments will only be necessary to the extent that conversion or write-off of AT1 was required, and deemed insufficient for recapitalisation.” (WBC) Market reactions… Concerns the world was hurtling toward another financial crisis triggered a flight to quality in the past week or so. Bonds yields plunged and risk assets were abandoned with varying degrees of severity and indifference. Inflation risk was consigned to the back seat with a growing belief the Fed, ECB, RBA et al would be forced to halt their rate hike activities in order to preserve financial stability. The ECB, then the Fed has subsequently proven these beliefs to be wrong, for now. The longer run concern now is with rate hikes continuing, and potential credit rationing following banking turmoil, one or more central banks will fall off the narrow path between containing inflation and supporting growth. Plunging yields suggest rate cuts are on the way. Three-year ACGB yields fell -82 bps to 2.818% while the SVB and then CS saga played out. Market implied terminal cash rate pricing went from pricing in two more hikes to pricing a pause, followed to cuts in coming months. The ASX 200 lost ground, down -6.50% over the period in question (vs -4.75% for the S&P 500), while major bank AT1 lost -4.00% - 5.00% in local markets, and as much as -10.0% in US markets. Bank credit spreads widened, +15 bps at their worst, with 5Y indicative spreads rising from +91 bps to +106 bps (green line in the first chart overleaf). As I type, major bank senior spreads are back around +98 - 99 bps vs a long run average of +95 bps. Tier 2 spreads have been modest in the grand scheme of things, around +15 bps wider, possible +20 bps to +225 bps for 2028 callable paper. It is worth noting the relative stability and resilience of A$ bank spreads, and A$ credit spreads in general. Not just through the recent hiccup, but other incidences of market dysfunction also – A$ spread performance is adhering to the historical play book. The SVB situation came to a head on March 8th (when they announced a capital raising and sold long-dated government bonds at a heavy loss). For the sake of this exercise, we’ll look at month to date performance, just because. US and EU financial spreads are +40 bps and +30 bps wider MTD, which is a 30% to 40% move. At their peak, US and EU financial spreads were around +55 bps wider in each. A$ financial spreads are +3 bps or +4 bps wider over the same period, or around 3% to 4%, peaking at +6 bps to +9 bps. We expect A$ spread resilience to persist, and while the US banking sector remains somewhat in a state of flux, we feel regulators have done enough now to prevent a further meaningful sell off in spreads – beyond the wides already seen at least. This document is intended to provide general advice and information only and has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFS license number 230347 without taking into account any particular person's objectives, financial situation or needs. Investors should, before acting on this general advice and information, consider the appropriateness of this general advice and information having regard to their personal objectives, financial situation and needs. Investors may wish to consider the appropriateness of the general advice and information themselves or seek the help of an adviser. Mutual makes no guarantee, warranty or representation as to the accuracy or completeness of the general advice and information contained in this document, and you should not rely on it. The financial products referred to in this flyer are interests in the registered managed investment scheme known as MIF, ARSN 162 978 181 (“product”). Mutual is the Responsible Entity and issuer of the product. Investments can go up and down in value. Forecasts and projections are based on assumptions and information and reflect the reasonable expectations of Mutual available at the time. Actual results may be materially affected by changes in economic, taxation and other circumstances. The factors that could cause actual results to differ materially from the projections include, among other things, changes in interest rates, changes in general economic conditions Past performance is not a reliable indicator of future performance.

  • There is a degree of caution as the RBA moves too hard, too fast

    “There is a degree of caution as the RBA moves too hard, too fast” Mutual Limited CIO Scott Rundell answers the top questions financial advisers are likely to receive from clients concerned about interest rates rises. As the RBA hikes rates, Bank Bill Swap Rates (BBSW, a reference rate) move higher, often ahead of the RBA moves. All securities held in Mutual’s funds (except the Mutual Cash and Term Deposit Fund - MCTDF) are floating rate notes, whose coupons are set as a fixed margin to BBSW and every 30 days or 90 days, their coupons are reset. So, if the RBA is hiking, and BBSW is hiking, the coupon and running yield of Mutual’s funds generally go up with it. With MCTDF, the term deposits are closely aligned to BBSW, and can be expected to increase as well.

  • Update: Inflation, Wages, and Interest rates…

    Global inflation is running hot and Australian households have not been spared the pain. As at the end of December, consumer prices (‘CPI’) had risen +7.8% over the year, more than double the growth rate from a year earlier (+3.5% YoY), and well north of the RBA’s target range (+2.0% - 3.0% YoY). Economic reality is such that inflation is bad, accept it. In order to contain inflation, the RBA has hiked the official cash by +325 bps from 0.10% in April last year, to 3.35% at the February meeting. This represents the most aggressive rate hike cycle on record, and as Tim Shaw would say, “But wait, there’s more.” At its last meeting the RBA signalled the need to raise rates a “couple” more times to combat inflation, which is generally assumed to be two more +25 bp hikes at a minimum, which would take the cash rate to 3.85% (base case). Subject to how the data plays out, there is risk of rates going higher again, potentially reaching 4.10% or even 4.35% as the absolute worst-case scenario. The surge in inflation has been driven by various factors, although three core reasons are generally accepted as the main drivers. First, supply chain disruption in the face of surging demand post the pandemic. Second, many advanced economies made a stronger-than-expected recovery from the pandemic thanks to an abundance of fiscal stimulus (i.e. JobKeeper payments) and extraordinarily loose monetary polices (i.e. very low interest rates). And third, commodity prices have risen sharply, which was exacerbated by Russia’s invasion of Ukraine. Most of these inflationary influences would normally be considered temporary. However, there is risk that with tight labour markets, wages will increase to compensate for higher prices, which could trigger a ‘wages-price spiral’. This could in turn entrench inflationary expectations, keeping prices elevated, and in turn keeping interest rates higher for longer. The Australian Wages Price Index (‘WPI’) published earlier today, indicating that wages for local workers have risen +3.3% YoY to the end of December, a ten-year high and up from the +2.8% YoY a year earlier and higher than the long run average of +3.1% YoY (1998 – now). With the RBA in the midst of an arm wrestle with inflation, upwardly trending wage growth is an area of focus and concern for the central bank. Historically, growth in the WPI has exceeded the prevailing CPI growth rate more often than not, which could arguably be put down to productivity gains given inflation over time has typically been trending lower, or at least within target ranges. Wage inflation without productivity gains is a concern, which is the risk we’re seeing now. With CPI running at +7.8% YoY, well outside the RBA’s +2.0% - 3.0% target range, the central bank is sweating moderate sized bullets that wages growth could get out of hand and spark a ‘wage-price spiral’. This remains a contributing factor to the RBA’s continued hawkish rhetoric on monetary policy settings and will keep the cash rate trending higher for at least another 2 – 3 months. Further, we do not expect the RBA will pivot on a dime and begin cutting rates any time soon. The ‘higher for longer’ narrative persists. Where does one park their ‘defensive’ capital allocation during such times? As a firm, we’re a strong believer in floating rate notes, which largely immunises investors against interest rate risk vs say a fixed rate bond. Monetary policy rhetoric remains hawkish, and it’s hard to argue against the likelihood of higher interest rate over the near to medium term. Since the RBA kicked off the current rate hike cycle (April 2022), fixed rate bonds have lost between -2.80% and -3.33% across Australian Government Bonds and State Government Bonds (Bloomberg AusBond Indices). The fixed rate credit index has lost -0.61%. Over the same period, Mutual Limited’s various retail funds have delivered returns of +2.18% for the Mutual Income Fund, +3.08% for the Mutual Credit Fund, and +5.51% for the Mutual High Yield Fund. Based on market pricing for forward cash rates and expectations around credit spread trends, these funds are expected to return +5.90% YoY, +6.60% YoY, and +9.40% respectively for calendar 2023. This document is intended to provide general advice and information only and has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFS license number 230347 without taking into account any particular person's objectives, financial situation or needs. Investors should, before acting on this general advice and information, consider the appropriateness of this general advice and information having regard to their personal objectives, financial situation and needs. Investors may wish to consider the appropriateness of the general advice and information themselves or seek the help of an adviser. Mutual makes no guarantee, warranty or representation as to the accuracy or completeness of the general advice and information contained in this document, and you should not rely on it. The financial products referred to in this flyer are interests in the registered managed investment scheme known as MIF, ARSN 162 978 181 (“product”). Mutual is the Responsible Entity and issuer of the product. Investments can go up and down in value. Forecasts and projections are based on assumptions and information and reflect the reasonable expectations of Mutual available at the time. Actual results may be materially affected by changes in economic, taxation and other circumstances. The factors that could cause actual results to differ materially from the projections include, among other things, changes in interest rates, changes in general economic conditions Past performance is not a reliable indicator of future performance.

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Mutual Limited

Level 17 447 Collins Street

Melbourne Vic 3000

+61 3 8681 1900

+61 413 465 207

 

 mutual@mutualltd.com.au

DISCLAIMER

 

This website provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully. The information on this website does not constitute personal advice and does not take into account your investment objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to on this website, you determine whether the relevant investment is suitable for your needs, objectives and financial circumstances. You should also consider seeking independent financial advice, particularly on taxation, retirement planning and investment risk tolerance before making an investment decision.

Neither Mutual Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the repayment of capital or payment of particular rates of return on investments. Mutual Limited publishes information on the website that to the best of its knowledge is current at the time and is not liable for any direct or indirect losses attributable to omissions from the website, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.

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