M&G Investments, one of Europe’s largest bond investors, has launched a new sub fund to its flagship asset backed securities (ABS) fund, the Lion Credit Opportunity Fund plc. The new strategy allocates only to investment grade bonds, typically backed by UK, German or Dutch mortgages, with credit ratings of AAA, AA or A.
Bonds such as this, argues M&G, are currently amongst Europe’s most secure assets. This is because the bonds are secured on pools of well established prime mortgage loans, often with low loan to value rates. Should individual underlying loans default losses are absorbed by up to three buffers in front of the bondholders: first is the mortgage borrower’s equity in the property and, in the case of residential mortgage backed securities (RMBS), second is the bank, via excess loan margin (better known as excess spread) on the whole pool of mortgages, and third is the bank again through an additional reserve fund.
The prime mortgage section and the senior bond section of the ABS market is distinct from what M&G would consider much riskier credit propositions such as junior sub-prime UK RMBS, collateralised debt obligations (CDOs) or junior commercial mortgage backed securities (CMBS).
In addition to strong fundamentals, pricing of prime RMBS remains robust, in spite of the on-going European sovereign debt crisis. Moreover, a spate of well received new issuance over late summer and early autumn has boosted market sentiment. M&G believes the market’s outperformance compared to equities and other areas of credit demonstrates that prime RMBS, particularly at the senior end of the capital structure, will draw more investors interested in senior and secure assets.
By allocating to higher rated bonds (according to M&G’s own internal credit ratings) in the RMBS and CMBS sectors the fund managers will create a portfolio aiming to deliver returns some 3-4% above LIBOR, the interest rate at which banks lend to each other, and which should insulate investors from the worst of potential market shocks.
Patrick Janssen, Fund Manager of M&G’s Lion Credit Opportunity Fund plc, explains, “The big opportunity in asset backed markets is now prime residential mortgage bonds from Northern Europe. These robust securities, which are based on thousands of prime credit homeowners repaying their mortgage loans on their primary residences, are once again being seen by investors as one of the most secure assets available. Moreover, many bonds are still available at attractive levels. We also like senior 0-60% loan to value (LTV) commercial mortgages but are very cautious about junior mortgage paper.
“It is these secure bonds that our new fund will allocate to. It has room to buy a few assets from outside core Northern Europe RMBS but these will only be quality bonds purchased from forced or distressed sellers. We certainly won’t be compromising the overall defensive nature of the portfolio.
“The ABS market is certainly gaining more traction with institutional investors, especially those with long term liabilities such as pension funds and insurance companies. However, to be successful, you need huge resources to analyse the legal structure of the bonds, the creditworthiness of each issuer and the worth of the underlying properties in the loan pools.”
RMBS – one of Europe’s most secure assets?
A September 2011 S&P study concluded that consumer ABS cumulative default rates in Europe (which includes all RMBS) since mid 2007 was just 0.06%. In addition, for the entire European structured finance market, almost 70% of those deals issued pre-2007 with a AAA rating, retained that AAA rating today. Finally, while the overall cumulative default rate since mid 2007 for all European structured finance was just 1.2%, cumulative defaults for the US structured finance market for the same period was 9.7%*.
Within an RMBS, if underlying individual loans default, losses are absorbed firstly by the borrower via home equity, secondly by the bank via excess loan margin (better known as excess spread) on the whole pool of mortgages and thirdly again by the bank via an additional reserve fund. If underlying defaults on the entire mortgage pool are so high as to put the bank at risk, or if the bank defaults due to other reasons, it is comforting to know that the bonds and the underlying mortgages are senior and secured, ringfenced from other debtholders. Losses at the bond level are first worn by junior bonds (after the bank has taken both the second and third loss position), and gradually, then mezzanine bonds and lastly by senior bonds. Indeed, a scenario where there are losses on a prime AAA RMBS bond from a high street bank is very likely to wipe out the bank equity and junior debt completely far earlier.
M&G’s ABS capabilities
M&G started investing in European ABS in 2000, allocating selectively to the asset class from a broad range of pooled and segregated credit mandates, and now has investments totalling €13bn. The company set up its flagship Lion Credit Opportunity Fund plc for pension funds, insurance companies and other large institutions in May 2008. The fund, which invested throughout the financial crisis, now has invested assets of over €450m. The oldest sub-fund within Lion has so far delivered annualised and unlevered returns of 12.3% p.a., net of fees**.
* Source: S&P, September 2011
** Source: M&G Investments October 2011.
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