Cash & Liquidity Management
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Boosting Returns with UK Prime Mortgage-Backed-Securities

An Interview with Matthew Tatnell, Manager, Aaa-rated Sterling Liquidity Fund and Sterling Liquidity Enhanced Fund, Morley

The Institutional Money Market Fund Association (IMMFA) recently announced that money market funds under management in Europe have continued to rise to new records, exceeding €400bn (£317bn), an increase of 35% over the past year. Many of these funds have similar asset profiles including a relatively small allocation to an asset class which now has the potential to add some meaningful returns for investors compared with highly rated debt issued by conventional bank/corporate issuers. This asset class is called Residential Mortgage Backed Securities (RMBS) which consist of securities that involve the issuance of debt that is secured by a pool of mortgage loans that have a lien over residential properties. In order to comply with rating agency restrictions money market funds are encouraged to hold the senior AAA rated part of these debt structures in securities with an expected life of less than three years. Initially this may be a surprise bearing in mind the level of speculation about the mortgage market. However, the UK is a very different market to the US, the epicentre of the current credit crisis, and investors should seriously consider funds which include UK prime mortgages as part of the portfolio. In this interview, Helen Sanders, Editor of TMI talks to Matthew Tatnell, who oversees the management of Morley’s Aaa-rated Sterling Liquidity Fund and Sterling Liquidity Enhanced Fund.

Why would an investor consider mortgage-backed securities?

When UK mortgage-backed securities are structured, they have a high level of subordination (a class of debt in the structure with inferior rights and generally lower credit ratings) typically in the region of 8% – 12%. In addition to subordination the structure usually comes with a pre-funded reserve fund which can build up using excess cashflow (available after making payments to investors) if mortgage deliquencies rise. In addition substantial growth in the UK housing market over the past few years has resulted in an average of around 40% – 50% build up of equity in the underlying mortgages giving investors a great deal of comfort.

But aren’t house prices falling?

Although there has been a dip in some parts of the country, Morley have stressed RMBS structures based upon one of the worst possible historic scenarios of the late 1980s and early 1990s when house prices declined by over 20% in the UK. Even using this severity of fall we concluded that senior noteholders within an UK RMBS structure are extremely unlikely to experience credit degradation, bearing in mind the level of credit enhancement, let alone any chance of a credit loss.

What about returns?

Before the credit crunch, UK prime residential mortgage-backed securities typically delivered a spread of 10-20 bps over Libor for a number of years. As a result of the credit crisis spreads widened to almost 200 bps over Libor and yet the credit quality of the underlying assets remains largely unchanged. Morley considered this spread widening to be severely stretched and some structures represented good relative value. Since the crisis began back in August 2007 markets have recovered somewhat but spreads remain stretched at approximately 100bps over Libor. Morley anticipated spreads were unlikely to remain at their widest levels and now feel that over the medium to long term spreads will continue to contract helped by a number of factors including the ‘special liquidity scheme’ announced recently by the Bank of England allowing RMBS as collateral.