Rate Reality Check - Navigating the UK Mortgage Markets New

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Rate Reality Check

Navigating the UK Mortgage Markets

New Normal’

‘

Over the past few months, much has been written about the

pressure on the UK economy and housing market from rising

inﬂation and interest rates.

While the issues of higher rates have been well ﬂagged, we anticipate that headlines

surrounding rising arrears and delinquencies in the mortgage market will increase in

the wider press. In this piece, we will dive into the underlying dynamics and impacts on

the performance of the UK Non-Conforming (NC) and Buy-to-let (BTL) mortgage backed

transactions and how we have managed these growing risks.

Securitized Credit Team

BlueBay Fixed Income Team

§ The Institute of Fiscal Studies (IFS) estimates that should mortgage rates

maintain their current high levels, 1.4 million individuals in mortgage-

holding households in Britain could lose at least 20% of their monthly

disposable income after refinancing.

§ The transmission of higher rates and inflation has begun to impact the

consumer, as we have seen a modest pickup in 30+ days of arrears,

but still relatively minor to what we witnessed following the Global Financial

Crisis (GFC).

§ Between July 2021 and May 2022, we reduced UK residential mortgaged-

backed security (RMBS) exposure from 24.4% to 5.2% in our flagship

Investment Grade strategy, the BlueBay Securitized Credit Investment

Grade strategy, driven by these concerns and tightening valuations.

§ Today, we hold no exposure to BBB or lower-rated UK RMBS in our flagship

strategy and prefer more defensive profiles that are shorter in duration

and have lower loan-to-values within the underlying mortgages.

§ Should volatility increase due to negative headlines surrounding the

UK mortgage market, as an active manager, we remain positioned to take

advantage of opportunities that arise.

Key takeaways

September 2023

“Should volatility

increase due to

negative headlines

surrounding the

UK mortgage

market, as an

active manager,

we remain

positioned to

take advantage

of opportunities

that arise.”

Definitions

Within UK RMBS, there are typically three types of

transactions: Prime, Non-Conforming (NC), and Buy-to-

Let (BTL). We will focus on both the NC and BTL RMBS

markets as this is where the stress feeding through

from rising interest rates will be felt most acutely.

NC RMBS transactions comprise of residential mortgages

that do not conform to high street prime origination

criteria. NC mortgage origination plays a signiﬁcant part

in the UK due to the number of individuals who are either

self-employed, have impaired credit history or are unable

to conform to rigid underwriting processes for other

reasons. Morgan Stanley estimates that the median NC

borrower falls somewhere around the 7th-8th income

decile versus the 8th to 9th income decile for the median

UK mortgage borrower.

BTL RMBS transactions consist of mortgages originated

based on the rental income generated from a property,

with the underlying borrower typically a higher income

earner. There is a double protection element to BTL

mortgages, which is why 30+ arrears data tends to be

extremely low. Firstly, should the landlord default on

a mortgage payment but the tenants remain in place,

the servicer can step in to collect the rental income to

make mortgage payments. Secondly, should tenants

step away from the rental property, it is likely that the

landlord will continue to pay the mortgage due to full

recourse laws and potential cross-collateralisation with

other properties.

Introduction

The outstanding value of mortgages in the UK is over

£1.6 trillion (as at 30 June 2023), with approximately 1 in 3

adults holding a mortgage. Over the next 12 months, an

estimated 1.3 million mortgages will exit ﬁxed rates, with

about 50% currently on a rate of less than 2%. Interest rates

in the UK, as of the 22 August, are forecast to peak around

6.0% by the end of 2023, resulting in mortgage rates which

are typically priced using the 5-year swap at 5.7%.

As households roll off their ﬁxed-rate mortgages, this

could profoundly affect the UK consumer, especially if rates

and inﬂation remain at this level for longer. On average,

the increase in monthly payments will be £276, equating

to 8.3% of disposable income.

Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’

Source: ONS, as at January 9, 2023.

Figure 1: Mortgages Rolling Off

400,000

350,000

300,000

250,000

200,000

150,000

100,000

50,000

Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

<2% initial rate >2% initial rate

An important aspect to consider is the ratio of ﬁxed to

ﬂoating household mortgage debt. Over the past decade,

there has been a structural shift, with a large reduction

of ﬂoating-rate mortgages. These accounted for roughly

70% of the outstanding stock a decade ago but just 12.5%

as of Q1 2023. In addition, an increasing number of

households with ﬁxed-rate mortgages have opted to ﬁx

for ﬁve years rather than two. This shift means that the

transmission of higher policy rates to the effective interest

rate on the stock of outstanding mortgages is playing out

much slower this cycle.

Despite the slower transmission, the UK mortgage market

remains more exposed than the euro area and the US due

to the greater share of shorter-term ﬁxed-rate mortgages

between 1 to 5 years. Furthermore, as the likelihood increases

that rates will stay higher for longer, it is anticipated that

a greater number of mortgage holders will be impacted,

as reﬁnancing at higher rates will lead to a fall in disposable

income. In addition to elevated inﬂation rates, which remain

stubbornly high, this could lead to a pickup in delinquencies

as consumers are simply unable to afford increasing costs,

which will impact on the performance of UK NC and BTL RMBS.

1. High-quality mortgages - mortgages underwritten post-

GFC are much higher quality than pre-GFC. In the period

before the GFC, there was a considerable amount of

fraud during the underwriting of mortgages, and proof

of income was a significant area where the checks were

extremely poor.

2. Lower loan-to-value (LTVs) – in Q2 2007, the total

percentage of mortgages underwritten with an LTV

greater than 90% was 14.8%. As of Q1 2023, this stands

at 4.0% (Bank of England).

3. Unemployment outlook – the biggest driver of mortgage

delinquency rates is unemployment. The current

unemployment rate is 4.2% (as of August 2023), and we

forecast over the next 12 months for this to reach around

5%. Wage growth has also remained robust, with the year-

on-year 3 month weekly average earnings growth most

recently at 8.2%.

4. Risk-retention requirements – today, when an RMBS

deal is issued into the market, the originator, sponsor,

or original lender must always hold at least 5% of

the nominal value of the securitization. This means

that originators have ‘skin in the game’ as should any

underwritten mortgages fall into arrears or default,

they will also take a loss. This was not the case pre-GFC,

meaning that mortgage originators could underwrite

excessively risky mortgages with limited consequence.

Some mitigating circumstances are supporting the performance of the sector:

Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’

Source: Goldman Sachs, as at July 7, 2023.

Figure 3: Regional Comparison

Mortgages by length of initial ﬁxation (estimated)

100%

80%

60%

40%

20%

US Euro Area UK

100%

80%

60%

40%

20%

Up to 1 year 1-5 years Over 5 years

Source: Goldman Sachs, as at July 7, 2023.

Figure 2: Breakdown of outstanding household

mortgage debt

100%

80%

60%

40%

20%

100%

80%

60%

40%

20%

2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Floating Fixed (total) Fixed 2 years or less

Fixed 3 to 4 years Fixed 5 years

UK RMBS Collateral Performance

When analysing the underlying collateral performance

of UK RMBS in both the NC and BTL transactions, 30+ days

arrears remain low historically. Compared to pre-GFC

collateral, 30+ days arrears in NC and BTL transactions hit

a peak of 32.8% and 8.3%, respectively. This signiﬁcantly

differs from where we stand today at 3.9% and 1.2%. The

reason for this is two-fold, robust underwriting standards

and an extremely resilient UK job market. While it is likely that

delinquencies will increase over the coming months as rates

stay high, the structural protection from UK RMBS is extremely

robust, especially in the most senior bonds.

Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’

The graph, in ﬁgure 5, shows the cumulative loss rate of

non-conforming mortgages originated during 2007, which is

historically the worst-performing vintage of mortgages. When

comparing the cumulative losses with the structural protection

within RMBS bonds, the result is a bond highly unlikely to be

impaired by the current default outlook. For the BBB bond

to take a £1 notional loss of principal, it would require the

cumulative loss rate on mortgages to be approximately 12%

based on our estimate. For context, cumulative losses on the

2007 mortgage vintage hit a peak of around 4%. Higher-rated

bonds then require even higher loss rates to be impaired.

Source: Morgan Stanley, as at August 10, 2023.

Figure 4: Arrears Comparison

Source: RBC BlueBay Asset Management, Intex, Moody’s,

as at August 22, 2023.

Figure 5: UK RMBS Breakevens

Mar 2007

30+ days arrears (%)

30+ days arrears comparsion between pre and post-GFC Mortgage Pools

Oct 2007

May 2008

Dec 2008

Jul 2009

Feb 2010

Sep 2010

Apr 2011

Nov 2011

Jun 2012

Mar 2013

Aug 2013

Mar 2014

Oct 2014

May 2015

Dec 2015

Jul 2016

Feb 2017

Sep 2017

Apr 2018

Nov 2018

Jun 2019

Nov 2020

Aug 2020

Mar 2021

Oct 2021

May 2022

Dec 2022

Jul 2023

5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 101 105 109 113 117 1211

2007 Vintage Cumulative Loss AAA RMBS Breakeven

AA RMBS Breakeven A RMBS Breakeven BBB RMBS Breakeven

Non conforming post-GFC Mortgage Pools Buy-to-let post-GFC Mortgage Pools

Non conforming pre-GFC Mortgage Pools

Buy-to-let pre-GFC Mortgage Pools

Days

Cumulative losses (%)

Managing RMBS exposure in the strategies

When managing the strategies, we continue to monitor and

consider both the technical and fundamental risks from

a top-down and bottom-up perspective. While, in our view, UK

mortgages will remain challenged in the short term, it is not our

view, as illustrated in ﬁgure 5, that mortgage bonds will take

principal losses in the long term. However, UK RMBS remains

susceptible to mark-to-market volatility against the backdrop

of the weakening fundamental picture, as discussed.

For example, between July 2021 and May 2022, we reduced UK

RMBS exposure from 24.4% to 5.2% in our ﬂagship Investment

Grade strategy, driven by inﬂation concerns and tightening

valuations. We targeted the selling on lower-rated names

with all BBB exposure sold and the strategy holding onto only

two favoured single A positions (with the remaining bonds

all being AAA and AA rated). The average purchase price over

the period was 99.72 versus the average sell price of 100.02.

Exposure was cautiously added back during Q3 2022 as

the LDI crisis supplied an opportunity to source bonds

at attractive valuations. Positions were added exclusively

in AAA and AA bonds at an average price of around 96 for

AA risk between October and December 2022. So, while the

bottom-up opportunities were presented to add UK exposure,

we did so in very high-quality bonds, and overall, we remain

underweight to the current period with recent activity

focussed on relative value positioning.

Today, we hold no exposure to BBB or below UK RMBS,

deciding to reduce exposure and move up the curve where

we can source attractive levels. As summarised in the table,

we have preferred more defensive proﬁles that are shorter in

duration and have lower loan-to-values within the underlying

mortgage pools.

Source: RBC BlueBay Asset Management, July 31, 2023.

Figure 7: UK RMBS Exposure in BlueBay

Securitized Credit Investment Grade Strategy

While cutting exposure to lower-rated UK RMBS, the yield on

the portfolio has been protected by rotating into attractive

sub-asset classes where the strategy is able to take

advantage of more compelling risk-adjusted returns, e.g.,

Dutch RMBS. From the current macro-outlook on the UK,

we remain comfortable with the remaining exposure held

in the strategy and stay nimble should opportunities arise

as a result of increased volatility.

Source: RBC BlueBay Asset Management, July 31, 2023.

Figure 6: Investment grade Exposure in BlueBay

Securitized Credit Investment Grade Strategy

Aug 2021

Sep 2021

Oct 2021

Nov 2021

Dec 2021

Jan 2022

Feb 2022

Mar 2022

Apr 2022

May 2022

Jun 2022

Jul 2022

Aug 2022

Sep 2022

Oct 2022

Nov 2022

Dec 2022

Jan 2023

Feb 2023

Mar 2023

Apr 2023

May 2023

Jun 2023

Jul 2023

30%

25%

20%

15%

10%

Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’

Asset

Class Rating

Average

Yield

(EUR)

Average

Spread

Duration

Average

underlying

indexed

LTV Exposure

RMBS

AAA 5.0 0.9 52% 2.0%

AA 6.0 2.2 66% 8.0%

A 6.7 1.5 65% 1.3%

“ When managing the strategies, we continue

to monitor and consider both the technical

and fundamental risks from a top-down

and bottom-up perspective.”

Risk Characteristics

§ At times, the market for Structured Credit Securities

may dry up, which could make it difficult to sell these

securities or the strategy may only be able to sell them

at a discount.

§ There may be cases where an organisation with which

we trade assets or derivatives (usually a financial

institution such as a bank) may be unable to fulfil its

obligations, which could cause losses to the strategy.

§ Structured Credit Securities in which the strategy

may invest may not be at the most senior level of the

debt issued by the relevant issuer and, accordingly,

the strategy may be exposed to the risk that its claims

on the asset pool of any such note are subordinated

to other creditors in the event of an insolvency of

any such issuer, meaning in turn that the strategy could

sustain losses in such circumstances if it were unable

to recover its original investment.

§ Structured Credit Securities are often exposed to

prepayment and extension risks that may have

a substantial impact on the timing and size of the

cash flows paid by the underlying pool of financial

assets. In the case of prepayments, this may

negatively impact the return of the strategy as the

income generated will have to be reinvested at the

prevailing interest rates which may be lower.

Conversely, extension risk tends to increase when

interest rates rise as the prepayment rate decreases

causing the duration of Structured Credit Securities

to lengthen and expose investors to higher interest

rate risk.

§ BlueBay could suffer from a failure of its processes,

systems and controls – or from such a failure at an

organisation on which we rely in order to deliver our

services – which could lead to losses for the strategy.

Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’

This document was prepared by RBC Global Asset Management (UK) Limited (RBC GAM UK), authorised and regulated by the UK Financial

Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and a member of the National Futures Association

(NFA) as authorised by the US Commodity Futures Trading Commission (CFTC).

In the United States, this document may also be provided by RBC Global Asset Management (U.S.) Inc. (“RBC GAM-US”), a SEC registered

investment adviser. The entities noted above are collectively referred to as “RBC BlueBay” within this document. The registrations and

memberships noted should not be interpreted as an endorsement or approval of RBC BlueBay by the respective licensing or registering

authorities.

With respect to the investment performance presented, past performance is not indicative of future performance. Actual account performance

may or will vary from the performance shown because of differences in market conditions; client-imposed investment restrictions; the time of

client investments and withdrawals; tax considerations; economies of scale; portfolio turnover; the number, type, availability, and diversity of

securities that can be purchased at a given time; differences in the underlying currency of the assets in the account, and other factors. Client

assets managed using these strategies in separate accounts or different vehicles may be subject to restrictions, fees or expenses that are

materially different than those found in the non-US funds.

This document is conﬁdential and, without RBC BlueBay’s consent, may not be (i) copied, photocopied or duplicated in any form by any means

or (ii) distributed to any person that is not an employee, ofﬁcer, director or authorized agent of the recipient.

Information herein is believed to be reliable but RBC BlueBay does not warrant its completeness or accuracy. This document contains

information collected from independent third-party sources. For purposes of providing these materials to you, neither RBC BlueBay nor any

of its afﬁliates, subsidiaries, directors, ofﬁcers, or employees, has independently veriﬁed the accuracy or completeness of the third-party

information contained herein.

The information contained herein does not constitute investment, tax, accounting or legal advice. Recipients are strongly advised to make an

independent review with their own advisors and reach their own conclusions regarding the investment merits and risks, legal, credit, tax and

accounting aspects of all transactions. Any risk management processes discussed refer to efforts to monitor and manage risk but should not

be confused with and do not imply no or low risk. No chart, graph, or other ﬁgure provided should be used to determine which strategies to

implement or which securities to buy or sell.

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Rate Reality Check - Navigating the UK Mortgage Markets ‘New Normal’