Why insurers should consider investing in pools of residential mortgages and consumer loans?

Partner Authored Content: Russell Lee, Head of Insurance Solutions, Jerome Henrion, Director of Private Assets, Fixed Income and Matt Jones, Director, Fixed Income at M&G Investments, explain why making a strategic allocation to residential mortgages and consumer loans could be beneficial for insurance investors.

Insurance Investor Promotional Contentposted on Tuesday, November 10, 2020

This article was produced by M&G as part of their valued Industry Partnership to Insurance Investor. To read their full report, “Why insurers should consider investing in pools of residential mortgages and consumer loans?'', please click here.


Defining the investment opportunity

Loans to individuals, whether residential mortgages or other forms of consumer finance (such as auto loans, credit card receivables and student loans), comprise one of the largest and most diverse credit asset classes globally. They provide an attractive, scalable, opportunity for insurance investors to diversify core fixed income portfolios which are currently under pressure from downgrade and default risk on corporate bonds.

In the UK and Europe, consumer lending has historically been dominated by retail banks, and until relatively recently large parts of the market had been inaccessible to all but a small number of institutional investors. Unsurprisingly, few insurance investors have any kind of direct exposure to this broad asset class – notable exceptions being residential mortgage holdings in the Netherlands. Prior to the introduction of Solvency II many insurers invested in securitisations of these assets, but they will be less familiar with the opportunity to invest directly by acquiring whole loan portfolios.

Caps on banks’ leverage ratios are creating opportunities for institutional investors to acquire portfolios of loans. Retail banks with large portfolios of high-quality residential mortgages are disproportionately affected. The pipeline of potential investment opportunities in residential mortgages and consumer loans is huge – in Europe, a steady-state annual opportunity set of even 5% of the market size of €7 trillion implies an annual addressable market size of €350 billion for portfolio acquisitions.

Why invest in residential mortgages and consumer loans?

Generally, households in the UK and Europe deleveraged after the global financial crisis and improved their creditworthiness. Regulators made residential mortgages and other consumer loans lower risk by imposing rules on bank lenders regarding borrower due diligence, therefore aiming to prevent consumers from borrowing at unsustainable levels. Residential mortgages and consumer loan margins have remained stable, and high, even as corporate bond yields fell in the years since the financial crisis. The widening in corporate credit early in 2020 has now largely reversed, so once again residential mortgages are looking particularly attractive, with low historical loss rates on prime mortgages in the UK and Europe.

We believe direct residential mortgages are a very high quality investment, and suitable for replacing corporate bond holdings in order to: 1) improve diversification, 2) mitigate downgrade risk, 3) reduce capital requirements, and 4) improve potential return on capital. Our analysis indicates that even under fairly severe stress testing, portfolios still can deliver positive returns. Unsecured consumer loans are more comparable to ‘crossover’ risk, with higher margins in order to compensate for the additional risk. They also provide a diversification benefit, but are more suited to a satellite holding than a core part of the portfolio.

Given the level of government intervention in the current crisis, which has effectively focused on ‘backstopping’ the consumer through extensive wage and unemployment support measures, we believe credit performance will remain resilient. However, the additional security available with residential mortgages, together with the ability to set conservative underwriting criteria, will make these particularly attractive.

Additional advantages for insurers

For European insurance investors, the capital treatment under the Solvency II standard formula for investing in both low-risk residential mortgages and higher risk, higher return, unsecured consumer loans is very favourable, which as a result, could enhance return on capital metrics.

Residential mortgages, unlike investment grade corporate bonds and most other asset classes, sit under the counterparty default risk module under the Solvency II standard formula. This means that adding residential mortgages to an investment portfolio acts as a valuable diversifier, not just from a risk perspective but also from the perspective of calculating the overall solvency capital requirement (SCR). These findings form part of our overall SCR analysis presented in our latest paper, ‘Residential mortgages and consumer loans – A new investment avenue for insurers?’, where we demonstrate how the combination of higher returns and lower capital charges on both residential mortgage investments and consumer loan investments could lead to a much higher expected return on capital than for equivalent corporate bonds, respectively.

To find out more click here.

The value of investments will fluctuate which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where mentioned, past performance is not a guide to future performance.

For Investment Professionals only. This article reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook. Issued by M&G Investment Management Limited (unless stated otherwise), registered in England and Wales under number 936683 with its registered office at 10 Fenchurch Avenue, London EC3M 5AG. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority.


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