The part of the fixed income market immune to bond market chaos

You’ve probably never thought about home loans and mortgages in the context of income before. Why would you? It’s normally one of the biggest pain points for a household and discussed in terms of how much it is adding to overall cost of living.

But, there’s a good reason why banks, insurers and non-bank lenders happily hold large pools of residential property mortgages – and it’s far from altruistic.

Think of the bigger picture.

Mortgages are loans with, for the most part, high-quality security in the form of a property, and repayments and interest paid at minimum monthly – but potentially weekly. Australia has strict lending standards and a property market that is in high demand with growing prices.

In fact, CoreLogic estimates national home values have soared 39.1% in the past five years. Defaults in Australia aren’t high – but even in the case of a default, a lender can take possession of the property and sell it to recoup their money in a strong market.

Starting to see the appeal to an institution? It’s undeniable, but I’m sure you are questioning where this helps your own portfolio.

While you may think the value of Australia’s $2.4 trillion mortgage market may exclude any non-institutional investors from ever experiencing the benefits, there are funds that exist that invest specifically in this market. I spoke to Michael Frearson, Director, Head of Fixed Income, Real Asset Management, to understand more about what this market looks like from an investment perspective and how you can invest.

Where does it all fit in the credit market?

From an investment perspective, mortgages come under the category of whole loans, part of the fixed income or credit market. The difference between whole loans compared to traditional instruments like bonds or Treasuries, comes down to who is the borrower and who is the lender.

“In any fixed income investment, investors are lending money to someone. There are terms of issue, a fixed repayment period and fixed maturity. 

For traditional fixed income assets, like bonds, the loan is from the retail investor to the financial institution or corporation.

For whole loans, like residential property mortgages, the loan is from the financial institution to the individual - it's the reverse," Frearson explains.

Frearson adds that, just like with the broader expanse of the credit market, there are a wide range of risks and potential returns in the whole loans category depending on the type.

“We focus on low risk secured residential lending, but other parts of the whole loan market extend to higher risk property development or corporate unsecured, unregulated lending,” Frearson says.

Real Asset Management is an originator of the whole loans it includes in the Real Income Fund through Brighten Home Loans (Brighten) which it owns. Brighten originates around $250 million worth of home loans every month via mortgage brokers.

When it comes to margins of safety, Frearson says "our average loan-to-value ratio is around 64% and loan arrears are historically lower than major banks." He explains that Brighten services those clients who are high quality but don’t fit the normal bank mould for loans, for example, those who have small-medium sized businesses.

Brighten aims to offer a higher level of specialised service to these clients and accordingly, is able to garner a slightly higher yield compared to the banks.

Whole loans and RMBS

Many of you out there may now be wondering how this also relates to things like residential mortgage-backed securities (RMBS) – another popular part of the market which benefits from Australia’s rising property prices.

To put it simply, the whole loan is the original unbroken, unsecuritised loan, the full mortgage for example. You can still sell whole loans to investors, you just need to have a large scalable business to support the origination, servicing requirements and accounting.

The difference between whole loans and RMBS is about structure and size.

RMBS are when an institution creates a debt security package that is backed by a pool of loans. The debt security is structured into different tranches (different levels of risk and returns to account for those risks) which are sold to investors.

Frearson points out that if he needed more liquidity for his portfolio, it would be an option to package up the whole loans into RMBS securities via RAM's inhouse Treasury team, or simply sell the whole loans to its $2bn-plus funding platform of bank-funded warehouses. 

"All our loans are portable across the funding platform and suitable for issuance into RMBS term markets which provides us with a unique competitive advantage," he says.

The only part of the credit market immune to bond market chaos

“The key reasons to hold whole loans over other common fixed income instruments includes capital stability, high levels of security and credit quality, along with higher levels of income compared to public market fixed income securities and funds,” says Frearson, who invests 35% of the Real Income Fund in this space.

In the wake of the recent bond market sell-off and the ongoing uncertainty in markets, Frearson adds that whole loans in the residential space are effectively immune to the chaos.

“The good thing about home loans is that they trade at face value plus accrued interest. There’s been no impact from the recent bond crash, nor from the changing rates cycle. The rate cuts have started to flow through to mortgage rates, which improves asset quality, but whole loans are still offering a very healthy premium compared to base rates,” Frearson says.

The reason behind this, Frearson explains, is that the terms of whole loans are set at the front end and based on the competitive lending environment so market movements have less of an impact.

By contrast, he is starting to see an increase in yields in traditional fixed income instruments in public markets.

“With global uncertainty and volatility spiking public markets, credit spreads moved around 10-20 basis points wider in the AAA segment, and around 20-30 basis points wider in the mezzanine segment. They still look expensive compared to private markets,” he says, explaining that if the sell off continues though, they may start to look attractive as inclusions in his portfolio.

He also highlights that whole loans are highly liquid allowing him to move quickly if he decides to jump on opportunities in the public market, but this liquidity is only available for large investors with extensive funding facilities in place of $2bn-plus. (He’s currently eyeing BBB tranches which recently traded at a margin of 180 basis points but are now available for 200).

Managing risks in the market

Memories are still long in the market following the global financial crisis (GFC), and investors may still feel concern over risks from investments related to mortgages and property loans.

The strength of Australia’s regulatory environment should act as one form of reassurance. Frearson also highlights that whole loans are one of the few investments that “tick all the boxes for the five Cs of credit”.

These are:

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions

“We have a robust credit policy at the front end to review the character of the borrower and verify their capacity to pay based on regulatory requirements," he says.

"We also set conditions at the start that borrowers need to meet, such as income verification, having mortgage insurance if the Loan-to-Value Ratio (LVR) would be above 80%, insuring the property and having capital upfront,” he says, adding that the collateral comes from the 100% secured position in the property.

The funding that Real Asset Management uses to offer these loans comes from its wholesale funds, as well as top-tier banks and institutional capital – which conduct their own regular strict due diligence on the entire lending operations and policies.

Whole loans and suitable investors

As a result of the risk framework and high quality of these types of whole loans, Frearson believes these types of investments are suitable for most investors, including retirees, who are looking for high-quality consistent income.

“It can offer equity-like returns for a lower level of risk and can fit in the defensive income component of a portfolio,” Frearson says, highlighting that his portfolio currently generates an 8.1% yield with capital stability and monthly liquidity.

It's certainly something for investors to mull further - the idea of generating an income from those very instruments we often complain so much about in our daily lives and in a part of the market that continues to grow due to high demand.