Australian housing: it pays to be conservative

July 3, 2020
Australian housing: it pays to be conservative

The COVID-19 pandemic and subsequent economic downturn has provided resets to valuations across most asset classes. In this note, Phil Strano, Portfolio Manager of the Yarra Absolute Credit Strategy, looks at the opportunities opening up in the Australian residential mortgage backed security (RMBS) market. 

Given the propensity for markets to overreact, the key question for all investors right now across all major asset classes is whether market pricing accurately reflects true risk. One trend which has been particularly noticeable to us has been the widening of spreads in Australian RMBS: since the onset of COVID-19, mortgage backed spreads are now trading approximately 50% wider and, critically, roughly 2.5 times wider than comparable corporates (refer chart).

While COVID-19 has rightly brought the path of Australian housing into focus, our base case remains that Australia’s housing market will not collapse. With volatiliity comes opportunity; RMBS investors have been able to capitalise on this widening in credit margins, rotating into higher quality tranches offering superior protection from future defaults and house price declines without sacrificing returns.

For example, we have recently observed opportunities offering credit margins above 300 bps for high Investment Grade (IG) A-rated RMBS. In some cases, credit margins above 325 bps have been observed, backed by conservative scenarios protecting against a 30% decline in property prices and loan defaults of 10% of the highest LVR borrowers. Pre-COVID-19 the credit margins on these securities offered 250 bps and lower.

Double digit default rates and 30% property price declines, it should be noted, remain a highly unlikely eventuality given historical precedents (i.e. GFC) and the significant government and regulator support for households and the housing market more specifically.

COVID-19 uncertainty is also resulting in favourable loan selection, with issuers pooling the strongest borrowers in RMBS collateral pools to secure investor support. Despite the economic contraction, the underlying loans in recent deals have no exposure to hardship or arrears, providing confidence that these pools will outperform in the years ahead despite the challenging economic outlook.

Notwithstanding our neutral stance on Australian housing, given current uncertainties and the wider credit margins available, it pays to remain conservative. Balancing downside risks with expected returns remains critical, hence our preference for high IG single A tranche issues.

We recently participated in the prime Columbus Capital Triton 2020-2 transaction, priced at a credit margin of 350 bps, roughly 100 bps wider than similar rated tranches before the onset of the pandemic.

The opportunistic risk/reward available in Australian RMBS helps underpin a yield of ~4% from Yarra’s strong investment grade portfolio, offering attractive returns in what is likely to remain a yield starved environment.