Value emerges in Prime RMBS amid hunt for yield

The recent rally in European fixed income has partly been driven by improved economic sentiment, falling inflation expectations, and a more accommodative monetary policy outlook from the European Central Bank (ECB) and the Bank of England (BoE).

Despite this, residential mortgage-backed securities (RMBS) and auto asset-backed securities (ABS) have not seen the same degree of spread tightening as investment grade and high yield corporate bonds, leaving them more attractively priced relative not only to other fixed income instruments but also to more specialised ABS sectors such as buy-to-let (BTL) RMBS and non-conforming (NC) RMBS.

Currently there is only around 20bp of spread premium available for investors buying BTL RMBS over Prime (bank-originated) RMBS (see Exhibit 1), while for NC there is probably an additional 5-10bp of spread on offer. Significantly, AAA UK Prime spreads have barely moved in the last two years while most other risk assets have seen significant tightening (a similar trend can be observed in the covered bond market).

With a premium of just 20bp for specialist mortgage risk over Prime RMBS, the latter starts to stand out as cheap, particularly given the BTL upside was more appealing in Q1 2024 when it was around 50bp. This imbalance of spreads is also evident in Dutch and French Prime RMBS, as well as in short-dated German and UK auto ABS from captive lenders (Volkswagen, Mercedes, Stellantis etc.). Prime RMBS and short dated captive auto ABS are among the most liquid products in the European market. They are virtually all eligible as collateral for cheap central bank funding, making bank treasury accounts the key investors. While some spread tightening has occurred in European RMBS and auto ABS, the UK has notably underperformed in recent months.

So why is this happening, and is there a trade?

One possible explanation is increased primary RMBS supply from banks, as they have returned to traditional funding tools now that free money from the BoE and ECB is a thing of the past. As a result, the share of Prime versus BTL and NC RMBS supply increased by around 30% last year. Another possible explanation is that the economy is holding up reasonably well and consumers have been coping with higher rates and persistently high inflation, mostly because unemployment has not risen by much. This has made investors more comfortable owning higher risk ABS products such as BTL and NC RMBS.

However, perhaps the most important factor has been a wider hunt for yield in what is a tight spread environment, though it is worth saying spreads in European ABS are less tight on a historical basis than more mainstream fixed income markets. Looking at book coverage levels and distribution statistics of recent primary deals, we can see AAA demand is highest for higher spread products like BTL and NC RMBS and collateralised loan obligations (CLOs). The share of asset management investors in these deals is unusually high, and we are also seeing a much higher proportion of non-UK buyers than normal in BTL and NC RMBS compared to Prime RMBS. This tells us asset managers are rapidly deploying cash into higher risk products in search of yield, and for European asset managers this is partly being driven by the ECB cutting rates more aggressively than the BoE. It also explains why European CLOs have been one of the best-performing asset classes so far this year.

This isn’t necessarily a bad thing, as European ABS still offers strong value in our view. The bigger point here is about relative value, because as one of the lowest-risk asset classes in fixed income, UK Prime RMBS at SONIA +50-55bp is starting to look like a very compelling alternative to specialist products such as UK BTL at SONIA +70-75bp.