PORTFOLIO POINT: Residential mortgage-backed securities offer greater diversification to high net worth investors.
The market’s appetite for the recently ASX-listed fixed-income transactions is a testament to the growing demand in Australia by retail and high net worth investors (individual investors that meet the wholesale investors test) for fixed-income products.
Outside of the listed fixed-income market, high net worth investors can put their money into a term deposit, a fixed-income fund, or they can invest in a few institutional corporate bonds (these securities are not available to retail investors).
However, high net worth investors still may have a problem achieving diversification in their fixed-income portfolio with corporate bonds due to high minimum parcel sizes.
When fixed-income products are issued in the Australian institutional market, the information memorandum that governs each deal will dictate the minimum parcel size that can be traded. These amounts vary, but most corporate bonds in Australia have a minimum parcel size of $500,000. There are some that can be invested in with $100,000, and a few can be traded in parcel sizes of less than $100,000.
The Australian dollar denominated bonds issued by AXA S.A. and Swiss Re (they come in both a fixed-rate form and a floating-rate note form) appear to be popular with high net worth investors but have minimum parcel sizes of $100,000. With these denominations, even a high net worth investor will find it difficult to avoid concentration risk within a balanced fixed-income portfolio.
Therefore, I believe high net-worth investors should take a close look at Australian residential mortgage-backed securities (RMBS) as an alternative to corporate bonds and term deposits to achieve better diversification in their fixed-income portfolios.
RMBS are fixed-income instruments that are backed or collateralised by a pool of individual residential mortgage loans.
RMBS have been a popular investment by the institutional market for a long time, and for good reason. The domestic market for RMBS is large and reasonably liquid. The outstanding market size for Australian RMBS, according to the Reserve Bank of Australia, is greater than $100 billion. This is more than twice as large as the domestic market for corporate bonds.
RMBS pay interest on a regular basis, usually monthly, and many RMBS assets return incremental principal amounts on the same monthly payment date. An RMBS that returns principal to the investor monthly can be an attractive proposition for investors, particularly those in pension phase. Also, when an RMBS pays down principal, the size of the outstanding principal can get quite small towards the end of its life. This makes them appealing to high net worth investors looking for diversification in their fixed-income portfolio.
The bond factor on an RMBS asset reflects the amount of principal that the security has paid down. If an RMBS asset has a bond factor of 0.10, it means that 90% of the principal has been returned or amortised down. This in turn means that if that if an RMBS has an issue size of $500,000, the tradable amount could be as low as $50,000.
Austraclear is the clearer for Australian RMBS. In order to clear smaller-sized trades it needs to get authority from the issuer. Because the amortising of principal of an RMBS can create small parcel sizes, issuers of Australian RMBS appear to be more sensitive to allowing smaller denominations to trade.
Australian RMBS can offer good relative value versus other fixed-income securities and also provide excellent security, which in certain structures can become even more secure as time passes.
During the global financial crisis, despite the turmoil in the markets, Australian RMBS performed extremely well.
RMBS allows investors to select different levels of risk and reward ranging from AAA-rated assets to lower-rated securities.
High net worth investors looking to participate in the RMBS markets may wish to start with higher-rated tranches. AAA-rated RMBS have traded at a yield to maturity of 6% to 6.5% for short-dated assets.
While AA- RMBS deals usually amortise a lot later in their life, and therefore it’s harder to come by smaller parcel sizes, they are useful in showing how cheap the entire suite of RMBS is on a relative value basis.
The table below compares AA- rated RMBS assets with similar rated assets in the market with three years to maturity.
It is difficult for high net worth investors to achieve a diversified fixed-income portfolio in Australia. Investing in Australian RMBS will help reduce concentration risk.
Chris Black is the head of Laminar Funds Management.