With ongoing noise around the sharp uptick this year in mortgage arrears, it’s important to consider the backdrop before hitting the panic button. With the Reserve Bank of Australia (RBA) unwinding artificially low rates with a series of rate hikes, so too are mortgage arrears ‘normalising’. Here we give context to the increase in arrears and what this means for RMBS securities.
Background
Faced with economic instability in the wake of COVID-19, the RBA cut the cash rate to an unprecedented 0.10%, and with it lowering the rates offered on financial products, including mortgage rates for borrowers.
However, following the pandemic, the RBA has significantly moved rates higher, at the time of writing at 4.10%, moving mortgage rates higher also. This has put pressure on borrowers, who are now paying more interest on their repayments, as shown in the below chart. While the interest received by investors on deposit rates has also increased (yellow bar), the increase in the interest payable (orange bar) for borrowers is far greater (circled in purple).
Source: RBA website
As the interest payable for households increases, and pent-up savings from COVID-19 times is depleted, this has contributed to an increase in the amount of borrowers falling behind on payments. However, it’s important to look across a wider data set to provide a clearer picture.
RMBS arrears
As touched on, with rates kept artificially low with unprecedented monetary policy, so too were arrears across Residential Mortgage-Backed Securities (RMBS), while also coinciding with an increase in the household savings ratio due to the COVID-19 pandemic restricting access to goods and services.
The chart below illustrates this period (as shown by the red arrow), where arrears trended lower when looking across a wider data set that dates back to 2017. It’s also worth noting, that when arrears did actually spike, around May 2020, which sits as an outlier over the data set. In comparison, we can see that from the start of 2023, arrears have trended higher (as we would expect to be the case), however, they don’t match that of the May 2020 spike.
Source: FIIG Securities, Bloomberg
The chart includes the aggregate of both prime and non-conforming RMBS transactions for each arrears period (i.e. 31-60 days, 61-90 days, 90+ days) from January 2017 to August 2023, and is divided by the outstanding amount to give a better comparison. The yellow line shows the balance outstanding for both prime and non-confirming deals.
As is evident from the chart, the ‘surge’ that has been commented on more widely, is a matter of arrears normalising to prior levels. Looking at the underlying data on a monthly basis, RMBS arrears fell 3 basis points (bp) for the month of July to 1.35% and have slightly moved higher by 1bp over August to 1.36%. Despite the move higher, it remains from such a low base that it does not raise cause for concern.
It is a trend we expect to see continue into 2024, with the RBA indicating rates will remain ‘higher for longer’, although to what extent is the question. It’s also worth noting, that while the market has left the door open to one more potential rate hike this year (which could potentially see a cash rate of around 4.35%), the market is pricing in steep rate cuts next year with a cash rate of around 3.6% by the end of 2024.
There is a strong connection between the unemployment rate and RMBS arrears, with Australia’s unemployment rate currently very tight at 3.7%. The spike in arrears we earlier referred to over May 2020, had an unemployment rate at the time of 7.5% and arrears spiked to 1.8%. Although the current unemployment rate isn’t sustainable and is expected to soften with a weaker economy, there remains a significant buffer to match the levels seen in May 2020. According to the February 2023 Statement on Monetary Policy (with the latest release due out at the end of this month), the RBA forecasts an unemployment rate of 4.4% by June 2025.
It’s also worth noting most households are ahead of their repayment schedule by up to 12 months according to recent bank reporting. Although has borrowers come under pressure, these buffers will likely erode as refinancing to higher rates comes into play and adjusting to higher inflation/ cost of living expenses. Australia’s major banks have reported a higher provision coverage in the June quarter to account for the expected increase in arrears.
Conclusion
Overall, we remain comfortable with the RMBS space when looking at the current increase in arrears, which was inevitable with elevated rates and inflation as restrictive monetary policy was unwound. This type of instrument typically prices wider than vanilla corporate bonds and pays a monthly coupon, providing a more attractive return and frequent income stream. We generally see better value in the investment grade tranches of RMBS transactions, which provide a lower level of risk in comparison to the sub-investment grade tranches.
