TwentyFour Asset Management

Hard or soft brexit: The case for UK RMBS

White Paper
When UK Prime Minister Theresa May travelled to Austria in September to meet with European Union leaders, she was hoping to find enough support for her Brexit proposals to move negotiations forward with a view to a final agreement by November.

Instead, May was told that her Chequers plan – so named for the country residence where it was formulated – simply wouldn’t work. Widely interpreted as a humiliation for the UK, the summit left the prospect of the country leaving the EU in March 2019 without an agreement on future trading arrangements looking much more likely.

Markets in the weeks since Salzburg have reflected growing unease. Sterling, which before the summit had touched a two-month high against the US dollar of $1.33, has retreated below $1.30. We’ve seen spreads in the sterling investment grade corporate bond market widen slightly, though demand has been robust, and high yield issuers are continuing to show a reluctance to print bonds in the currency.

For investors, the most concerning aspect of the Salzburg standoff must be the level of apparent miscalculation of intentions on both sides. The UK government had interpreted positive comments from EU leaders about the Chequers plan being a “good starting point” for a Brexit deal at face value, as a sign that a future trade deal could be worked out broadly on those terms. EU leaders, meanwhile, misjudged the restraints placed on May’s government by internal divisions within her ruling Conservative Party, which render her apparently unable to compromise on key sticking points such as free movement and the Irish border.

While a compromise deal and a ‘soft’ Brexit remains our base case, and more recent comments from EU leaders have softened the negative tone of Salzburg, it is reasonable to expect a period of heightened volatility ahead. The increased prospect of ‘no deal’ has caused understandable anxiety among fixed income investors around UK assets, including UK residential mortgage-backed securities (RMBS).

We have consistently held a meaningful exposure to the UK RMBS sector, and regardless of the ultimate outcome of the Brexit negotiations, we wanted to share our rationale for maintaining this holding. We believe the features of UK RMBS outlined below will help protect prices and preserve investors’ capital if volatility rises, and investors willing to look through the headline risk to the fundamentals will have an opportunity to pick up a material spread premium.