8%-plus returns without big risks? This overlooked asset class could fit the bill

The Australian rate-cutting cycle is coming, and investors will need to think about where to find yield for their portfolio.

In recent years, the equity market has been a popular option but comes with higher risk than fixed income investments. Investors have also been increasingly open to alternatives, particularly in the private space, though understanding and awareness of the options are still growing.

Real Asset Management’s Michael Frearson believes investors should be looking at asset-backed securities, such as residential mortgage-backed securities (RMBS), noting their potential to yield equity-like returns of over 8% despite being more conservative, according to Frearson. 

The Real Income Fund, for example, which only invests in high-quality RMBS and asset-backed securities (ABS), has returned 8.35% in the last year, with Frearson quipping that these assets provide “boringly reliable" income.

While the concept of RMBS may bring to mind scary echoes of the GFC and the sub-prime crisis in the US, Frearson is quick to point out that the Australian environment is vastly different.

“Australian RMBS has a strong asset quality, underpinned by the very strong regulatory environment we operate within,” says Frearson.

Our lending environment is far stricter, with stringent income verification/serviceability checks on borrowers and regulated avenues for recourse in the event of a default, compared to the challenges seen in the past in the US.

In fact, Frearson argues it can be suitable for income-focused investors, including retirees because of the protective structures in play. He discussed this further in a recent interview.

The basics of the RMBS market

A very simple way of thinking of RMBS is as a pool of residential mortgages in one structure, designed to offer regular income payments. The structure is then broken down into different risk levels called "tranches", which offer different levels of risk and yield.

“Securitisation is a contracted process designed to provide certainty to investors and retain cash flows to benefit investors,” says Frearson, noting that the tranche structure is the same in public and private markets.

“In private markets, there’s a senior tranche, a mezzanine tranche, a junior tranche and/or a seller note. In the public markets, there are the AAA-rated components, the mezzanine tranches and then the equity notes that lenders retain.”

Frearson explains that the different tranches are structured with varying levels of subordination where higher rated tranches are protected by lower rates ones that absorb initial losses. These tranches, along with credit enhancements - features designed to reduce risk for investors - and mechanisms to retain excess income and maintain liquidity reserves, provide a safeguard against potential losses. 

"This means there is a buffer there to withstand any expected losses in the pool of loans," Frearson says. Additionally, insurance can also be incorporated within the structure to further protect investors.

While it may be a new concept for many, it could play a valuable role in the alternative bucket for conservative, income-focused investors.

“They have highly contracted revenue streams and capital stability from being floating rate investments. So, they're a great source of income for investors with high levels of capital stability. 

The reason why there's high levels of capital stability is because it's a contracted payment and there is also underlying security which underpins the investors receiving their face value back,” Frearson says.

The Australian RMBS market

The Australian RMBS market is no small fry, which shouldn’t come as any surprise given residential property could be called the great Australian obsession.

The market is approximately $160 billion in size, and Frearson highlights there was record issuance in 2024 with around $79 billion worth of transactions. This compares to around $40-50 billion normally.

“The composition of the market is around 80% RMBS and around 20% asset-backed securities, which is predominantly auto-lending, as well as some consumer credit, equipment credit and SME credit,” says Frearson.

Frearson highlights there was a strong rally across all areas of the credit market in the second half of 2024, including structured finance. This saw outsized returns in the RMBS and ABS market, but Frearson believes there is still strong relative value to be found.

“There were two factors for this rally. Economic performance was more resilient than expected – economies withstood the rate hikes and there was a soft landing. 

The second driver was the outlook for rate cuts, which will improve the credit quality even further over 2025,” says Frearson.

How RAM approaches investing in this space

Frearson notes that at RAM, the focus is on consistency of income, capital stability and minimising risk. As a result, RAM takes a very selective approach to the RMBS market.

The Real Income Fund excludes construction and development, focusing instead on well-diversified pools of high-quality mortgages and other secured credit facilities like cars and equipment.

“We don’t do direct lending. We don’t do development and construction projects which can risk you turning the debt investment into an equity investment. This is a risk we’ve seen quite a lot with development loans,” he says.

Before investing, RAM applies a “microscopic lens to the underlying borrowers and the quality of the mortgages”, and the products invested in are underpinned by ‘first mortgages’. This end-to-end ownership of risk is a key benefit of investing alongside a well-resourced non-bank lending business with 150+ staff and a $3bn funding platform from institutional investors and banks.

Importantly, secondary mortgages where investors refinance or take out an additional mortgage, often with a higher loan-to-value ratio and higher risk, are excluded from the investment universe.

Frearson has a preference for the mezzanine tranche in private transactions.

“That’s because we can get significantly higher credit enhancement. We have greater control over the pool of loans, the lending policy of the lender, and the liquidity features in that structure. Effectively, for a given risk level, we can get more credit enhancement and a higher return compared to public market offerings,” says Frearson.

For example, he explains Prime Australian RMBS structures typically have 1-2% equity in the securitisation structure, while private market options can have an equity buffer of 5% while asset-backed private structures can be higher again.

Could now be the time to invest in Australian RMBS?

Frearson sees a lot to like about the RMBS environment at present including an attractive yield and an easing environment set to be supportive of the asset class. 

He specifically points out: “Yields in securitised transactions are still at a healthy premium to corporate credit spreads. There is still approximately double the yield available in RMBS in mezzanine tranches compared to corporate.”

"RAM has a 7-year track record of delivering on our income objective with 100% capital stability," Frearson says, describing it as “boringly reliable income” - something that many investors are looking for in their portfolios these days. 

For more information on the RMBS market, including insights on how institutions have been investing in this space for decades and the diversification benefits it offers for portfolios, visit Real Asset Management's whitepaper here.