How you can enhance your income when interest rates fall

Rates have started to fall in global markets and Australia is tipped to follow suit in February 2025. Markets have already started to account for falls and all of a sudden, your fixed income portfolio is not generating the same yield it was just a few months ago. But where should you look instead to maintain your income? 

Michael Frearson, Director and Head of Fixed Income at Real Asset Management, is seeing an opportunity in an often-misunderstood asset class: securitised credit.

If this rings alarm bells for some investors, perhaps that relates to Residential Mortgage Backed Securities (RMBS). Frearson argues we shouldn’t confuse the high-quality Australian offering with its lower-quality American counterpart. Australian RMBSs are high quality, well regulated and  the investment grade segment has never suffered a capital loss. 

But what can securitised credit offer investors and how can it enhance your income? In this wire, I’ll explore the ins and outs with Frearson, who is 100% invested in this space for the RAM Real Income Fund.

What is securitised credit?

“In short, it’s a diversified pool of loans that are packaged together with some structural enhancements added to the structure to provide greater certainty of cash flows to investors,” says Frearson.

The loans can relate to any asset. While traditional residential mortgages are a well-known one, they could also refer to a range of other options like credit cards, car loans, or commercial equipment. 

The income for investors is generated from interest and principal repayments to the underlying loans.

Securitised credit also comes in different levels of risk, known as tranches – you’ll generally be offered a higher return for a higher level of risk. The typical structure for these tranches is junior, mezzanine and senior.

Senior tranches typically carry the lowest risk of loss because they have first right to the cash flows of the underlying loans compared to lower levels. Loans in the senior tranche typically hold credit ratings of AAA, AA, A and BBB, while junior tranches will hold BB and B.

“If you slice up a diversified pool of prime mortgages, the way it works is around 94% would be rated triple-A, around 3% would be between double-A and triple-B, and only around 1.5% to 2% of the portfolio would be rated non-investment grade,” says Frearson.

Frearson favours established non-bank lenders for secured loans and primarily uses RMBS, noting that banks are more likely to fund their loans with cash deposits. He has strict criteria for those he invests with.

“Given they are funded externally, they need to have robust risk management systems in place. They need to pass independent audits from their different partners and capital funders and the structure of their transactions needs to be industry-standard to achieve rating agencies' support and ratings. There’s verification all along the way,” he says.

Attractive yield in the current market

Even outside a falling rate environment, securitised credit holds appeal.

“You can pick up around 0.5-1.5% even for the equivalent credit rating. Consider AA-rated [securities]. A bank paper might get 70 basis points over, but you can get up to 200 basis points over for an AA-rated RMBS security,” says Frearson.

As we move into an easing cycle and look to secure certain income levels, securitised credit can offer a means of maintaining a better yield without necessarily taking on higher risk.

As Frearson points out, while term deposits have already dropped below 5%, it’s a different story in securitised credit.

“In the AAA space, you can still get yields around 5.5%-6%, which is very high quality and liquid. If you're happy to take a bit more risk, you can get yields of around 8%-10% by investing in the mezzanine tranche, the same high-quality pool of loans,” he says.

Reasons to be confident in the quality of Australian RMBS

RMBS is much maligned amongst investors – and while this isn’t unfair when you consider US RMBS and its role in causing the GFC, Australian RMBSs are a vastly different story. 

“One key difference is the regulatory environment. Lenders here need to verify income before they lend to people buying houses. That provides a greater level of certainty. The other key difference is the non-recourse nature of US mortgages compared to Australian mortgages,” says Frearson.

Australian mortgages have full recourse to the property along with any other assets a borrower may hold, thus greater certainty for the lender over repayment. It’s also worth noting that this regulatory environment has seen the Australian securitised credit space stand up well in tough times.

“We didn’t see any defaults come through the Australian RMBS market in the GFC, given the different regulatory and lending standards we operate within here,” Frearson says.

A growing space

APRA’s review of the Bank Capital Framework and the expected phasing out of AT1 Capital (ASX-listed capital notes) are anticipated to lead to a range of investors searching for alternative exposures to generate income with a similar risk/return profile.

In the short term, the planned changes create more certainty for Capital Notes, as APRA has flagged that all existing bank AT1 must be called before 2032. However, in the medium term, investors will need to look elsewhere to gain exposure to floating-rate credit. Frearson expects this to drive growth for both funds invested in Tier 2 Bank Capital and other defensive income solutions, including high-grade private credit funds.

He further points out that this regulatory shift presents an opportunity for growth in securitised credit markets, particularly through non-bank lenders, with two key growth drivers: supply growth and an increase in invested demand.

“Major banks are pulling out of a range of non-vanilla lending areas. This has created an opportunity for non-banks to grow their lending books and still provide exposure to a range of well-diversified, high-quality borrowers,” he says.

He credits the increased demand to the attractive yield relative to other asset classes. 

Understanding risks across the credit spectrum

Frearson addresses a common misconception that structured finance is inherently risky. “A key myth is that structured finance is risky, but it’s only as risky as the structure you invest in,” Frearson says.

“Investors need to understand the risks they are exposed to. An outsized return greater than double digits will mean taking some risk to achieve that. Investors need to take the time to understand what they are investing in and what risks are involved for the returns they hope to achieve,” he adds.

Frearson highlights that not all private credit carries the same level of risk. While the term "private credit" has gained popularity in recent years, it broadly refers to any debt not originated by an APRA-regulated bank, often without clear details regarding the investment’s characteristics or quality. Private credit funds can sometimes be poorly diversified and expose investors to higher-risk activities, such as property development, construction, or unsecured corporate debt - areas that RAM deliberately avoids.

He points out that privately issued MBS provides a high level of transparency, diversification, and protection, using the Real Income Fund as an example. “Our underlying loans are thoroughly assessed and backed by Australian real estate, giving investors clear visibility into the quality of the portfolio,” he says before adding:

“This combination of transparency, regulatory oversight, and sound lending practices results in a more stable and predictable income stream compared to riskier credit products, such as corporate debt or property development loans, where transparency, diversification, and security are often lacking.” 

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