Cash Investment: Tackling the headwinds

Chris Gaskarth of Institutional Investment Advisors explores the benefits of residential mortgage and asset backed securities.

Thinking about what to do with cash, local authority treasury managers are currently facing a number of headwinds:

• A reduction in UK government ownership of both RBS and Lloyds
• Multiple downgrades of previously strongly rated banks to long term ‘A’ or ‘BBB’, including RBS and Lloyds

So there are now:

• Smaller limits for eligible bank counterparties, by size and term
• Consequently, a smaller eligible investment universe for AAA rated money market funds

And to make it even more difficult

• Term deposits of < 1 year now offer lower returns due to the consequences of new regulations on bank liquidity
• Bail-in risk is now a real consideration

A review of treasury management strategies (‘TMS’) reveals that many local authorities and their treasury advisors are addressing such concerns by adjusting their permitted investments, e.g. by now including new assets classes such as covered bonds and tri-party repos.

We believe that selected AAA / AA rated residential mortgage and asset backed securities (‘RMBS / ABS’) from the UK and other core-European countries are also worth considering to further strengthen TMS.

However, in general, RMBS / ABS have been overlooked, possibly due to a lack of knowledge or awareness of their strength, stability and resilience through the challenges of both economic and market volatility, particularly over the last 8 years.

The DCLG¹  guidance on local government investments highlighted their three key investment attributes as security, liquidity and yield (in that order) – SLY.  These are all highly applicable to RMBS / ABS:

Security
The senior bonds from almost all core-European RMBS / ABS are typically rated AAA. There have been zero defaults in these bonds since the asset class began in 1987.

Most importantly however, they are all secured against pools of highly granular and transparent assets, just like covered bonds. But unlike covered bonds they are fully bankruptcy-remote from the issuing bank, meaning that they are completely immunised from any bail-in risk.

In addition, the bonds are typically issued as floating rate notes, thereby virtually eliminating interest rate risk. They are also usually fairly short dated, helping to keep mark-to-market volatility relatively low.

Liquidity
Being the most senior bonds, they have the largest issue sizes, often larger than a typical corporate or senior unsecured bank bond: with trading desks at all the major dealers they are at least as liquid if not more so.

In addition, the value and quality of these bonds has been recognised by central banks around the world. The BoE, the ECB and the Fed have taken hundreds of billions of senior RMBS / ABS on to their balance sheets as part of their various repo funding and QE programmes. For these purposes, central banks require asset classes that are both liquid and of the highest credit quality.

Of course, in the most extreme market conditions, liquidity in anything but the highest quality government paper tends to diminish significantly. However, even during the worst depths of 2008-2009 RMBS / ABS was still one of the few asset classes that the market was prepared to bid on, although prices were of course lower.

Yield
As can be seen from the table below, RMBS / ABS offer higher yields than covered bonds and short term unsecured deposits.  The following is a list of UK banks and building societies who have outstanding issues of RMBS, compared with senior unsecured 1 year CDs and secured but credit-linked covered bonds:

UK Banks and Building Societies – Comparable Long Term Credit Ratings and Spreads (bps vs 3mth Libor)*

*Composite Rating and Floating Rate Spreads.  3mth GBP Libor = 0.59%
Source: Bloomberg, TwentyFour Asset Management 1-Sep-2015

In addition, each RMBS / ABS issuer is a completely separate legal entity from the originating bank and can therefore also help to add diversity to local authority investment portfolios, therefore, in the UK alone, more than doubling the available number of potential investment names.

Total outstandings of prime RMBS from these issuers is comparable in size with both senior unsecured term debt (e.g. from MTN programmes) and covered bonds.  However, issues in both these markets have largely (approx. 85%) been in fixed rate form, adding an extra level of interest rate risk not found in RMBS, which could be swapped out but would then add an extra layer of bank risk to the holding and also further tie-up bank lines.

As with covered bonds and senior unsecured in the UK, whilst there is significant issuance in GBP, there are also bonds available from many issuers in EUR and USD.

Other Aspects

Credit Analysis
Unlike corporate or senior unsecured bonds, RMBS / ABS allow investment managers to carry out full and rigorous assessment of individual deals and stress testing of projected cash flows, both prior to their launch and on an on-going basis.

Typically, underlying asset performance is published promptly every month and in significant detail, unlike the annual and semi-annual reports from corporates or banks which also usually take some considerable time to be published.

Ways of investing in RMBS / ABS
An investment programme can be implemented simply and cost-effectively by engaging with an investment management team:

• that specialises in both RMBS / ABS and currency hedged solutions (if required),
• either in a AAA-rated bond fund and/or in bespoke Segregated Managed Accounts,
• supported by an independent custodian

A leading investment manager will be able to demonstrate broad and deep access to both the primary and secondary markets to support efficient trading and liquidity.

¹ Department for Communities and Local Government (revised 2010)

This article was sponsored by 

Institutional Investment Advisors Ltd. (‘IIA’) www.ininad.co.uk  advises on the design and construction of credit based asset portfolios, including RMBS / ABS, and arranges investments for institutional clientsincluding Local Authorities, Insurance Companies, Pension Funds and UK Banks. Chris Gaskarth (pictured), director, has extensive experience of treasury and credit markets. Chris is a qualified Member of both the Chartered Institute of Bankers and the Association of Corporate Treasurers, and also holds the Association’s Certificate in Pensions Risk Management.