TwentyFour Income Fund, which invests in securitised debt has decided to update investors on its views of mortgage markets. It says that it wants to provide more information about the risk that it has exposure to, and what mortgage lenders can do to help support borrowers if needed.
TwentyFour Income predominantly invests in debt securities from Residential Mortgage Backed Securities (RMBS) and Collateralised Loan Obligations (CLOs). It bought the UK Mortgages portfolio in March 2022, and therefore also owns a number of performing junior (lower-ranking) UK RMBS investments. It also owns some Dutch junior Prime RMBS investments, acquired in 2018 to 2020.
UK base interest rates are at 5% in June, with the current market expectation that they will hike rates further in August, and remain elevated in the medium term. For the fund this means that income for the portfolio will also increase in line with this increased rate due to its investment in floating rate securities.
This is good for TwentyFour Income’s shareholders, but it is mindful that higher UK interest rates also increase costs to homeowners with short term fixed rate mortgages, who will almost certainly have to refinance at higher rates. The portfolio manager prefers mortgage risk over unsecured consumer risk and credit cards, where they expect performance to deteriorate more than in mortgages, but not to the extent seen during the early 1990s or the global financial crisis in 2008, especially as inflation figures are moderating and it thinks that soft landings for the UK and European economies look more likely.
The manager says that it is happy with current positioning and has a high conviction on the fundamental performance of the borrowers that the company has exposure to, especially given the longer fixed periods and low Loan to Value ratios (LTVs) of the underlying mortgage portfolios [which make it more likely that the fund can get its money back if the borrower cannot pay interest/loan repayments].
Although lenders stress-test homeowners’ abilities to pay higher rates than they have been offered based on prevailing market conditions before granting mortgages, mortgage rates have increased quicker than most lenders will have expected. It is important to understand though that a mortgage is the most senior credit a consumer has and that in the UK (and in the EU) mortgage lending is done on a full recourse basis [meaning that the lender can take all of a borrower’s assets to repay the debt if the terms of the mortgage allow it].
Historically there are three main reasons for a borrower to fall into arrears; unemployment, partner separations and death. While inflation and higher resets will be problematic for some borrowers, there are typically other expenses that borrowers can and have historically cut down on in order to service their mortgages, and this is before taking into account recent wage increases that will help many borrowers manage their expenses.
There will, however, clearly be borrowers that do not have the luxury of high savings or additional disposable income, or have not seen significant salary increases. For these borrowers, mortgage servicers and lenders have tools at their disposal to help or mitigate losses, and although the regulator has guided lenders publicly on this recently, these are mostly things lenders (who have a duty of care to borrowers) have been doing for a long time, having learnt lessons from 2008, and more recently from COVID. Forbearance is therefore seen as a more efficient tool than foreclosures and ultimately minimises credit losses. The main tools that lenders have to help include:
- Budget coaching
- Maturity extensions
- Temporary switches from capital repayment to interest only repayment profiles
- Partial payment holidays (the idea being it is `better to pay 80% than nothing’), followed by capitalising missed interest
- Voluntary and assisted sales, typical for professional Buy-To-Let, especially when LTVs are low, which typically gives a better execution than a public auction
- Then if really nothing is possible, or if borrowers don’t engage with lenders, a repossession and sale is the ultimate defence lenders have
The portfolio
This year the manager has refinanced two UK mortgage transactions, the most recent being the refinancing of a pool of legacy mortgages (the Capital Home Loans portfolio) that publicly priced last week. This refinancing significantly improves the economics for the fund and it repays around two thirds of the invested capital, which can be deployed in other investment opportunities.
Following the latest refinancing, TwentyFour Income has 11 different junior RMBS investments, making up about 17% of the NAV.
Dutch Prime mortgages are typically 20 to 30 year fixed rate mortgages and as these investments were made in 2018-2020, the mortgage rates are very low and credit risk is therefore significantly different to UK mortgages. These account for about 6.1% of the portfolio and the average LTV is 64%.
For UK RMBS, the fund is invested in a mix of (professional) buy to let and owner occupied mortgage risk. Other than the Capital Home Loans portfolio investment, the rest of the RMBS are mortgage portfolios originated in recent years under strict affordability criteria. Most of these homeowners have benefited from substantial house price increases, which ultimately reduces their risk of negative equity and the risk of potential losses for lenders and holders of junior RMBS notes, due to a reduction in LTV ratios. Reduced LTV ratios also provide the servicers with more tools to help any borrowers who may be facing financial problems.
The manager says that the fundamental performance of UK Mortgage’s securities, as well as the Dutch Prime investments (in terms of arrears and foreclosures) is substantially better than that modelled at time of acquisition. It has tried to reduce risk in the UK Mortgage’s portfolio, in some cases switching from just owning the lower (riskier) tranches of debt to owning exposure to the whole portfolio of mortgages (what they call a vertical slice through the portfolio).
The manager remains comfortable with existing investments, and will look to further optimise these investments over time as they come to fruition. Bronwyn Curtis, chair of TwentyFour Income, shares this view and says “historically, UK mortgages have performed exceptionally well and although we recognise that the UK mortgage market is challenging, the board is happy with the active management of the portfolio by TwentyFour, and the very low LTVs of these investments.”
TFIF : TwentyFour Income updates on mortgage risk