The primary market for U.K. residential mortgage-backed securities (RMBS) securitizations has been volatile since early 2022, with spreads now substantially wider. This has prompted questions over the likelihood that outstanding RMBS transactions will be redeemed at their earliest optional redemption date, as step-up margins designed to help incentivize calls now seem low in the new spread environment, such as:

• Are there any relationships between an RMBS transaction's characteristics and its step-up margins?
• Do optionholders only factor in the unfolding transaction economics, or is reputational risk also a significant consideration?

To answer these questions, among others, S&P Global Ratings analyzed step-up margins for U.K. RMBS transactions that are set to reach their callable dates over the next 12 months, which may be a factor driving "call" or "no call" decisions. (To clarify, when discussing the timing, we hereby mean the outstanding U.K. RMBS transactions reaching their respective call dates. We do not consider new transactions in the future being issued and attaining their hypothetical call dates.)

The call option in an RMBS transaction typically gives the holder the ability to repurchase the underlying collateral from a securitization at a defined point in the future for a predefined amount, and in doing so, repay the tranche investors usually at par, including any accrued interest. The first call date is typically set at about three or five years after the transaction closes. At this date, the note margins typically "step up" to a higher level, intended to act as an incentive for originators to call their outstanding transactions to avoid higher funding costs, and giving investors greater certainty of the bonds' likely life. This incentive is most likely to be effective if the stepped-up funding cost is higher than the cost of refinancing the same collateral in the primary market at prevailing prices. Of note, turbo mechanisms trap interest receipts to repay notes after the callable date, leaving equityholders with limited or no cash flows.

Forty-Two U.K. RMBS Transactions Could Be Called In the Next 12 Months

In the next 12 months, 42 U.K. RMBS transactions that we rate have a call date on which the issuer may exercise their call options (see chart 1; the Appendix section contains a full list of transactions).

Chart 1

How RMBS Transaction Characteristics Relate To Step-Up Margins

In the following, we look at the relationship between a RMBS transaction's characteristics and its step-up margins. We define the step-up margin multiple for any tranche as the step-up margin divided by the initial margin.

The higher the rating on the class of notes, the higher the step-up margin multiple

Based on our analysis, a tranche's position in the capital structure--as proxied by its rating--is typically correlated with the step-up margin multiple: the higher the rating, the higher the multiple (see chart 2). Conversely, a higher initial margin on lower-rated classes of notes (reflecting the higher relative credit risk) is typically associated with a lower step-up margin multiple. For instance, while a 'AAA' tranche's margin might step up to 200 basis points (bps) from 120 bps (a multiple of 1.67x), a 'BB' tranche's margin may rise to 650 bps from 500 bps (1.3x). We found that this difference in step-up multiples across rating levels is statistically significant.

Chart 2

Vintage and length of noncall period also affect the step-up margin multiple

We previously found that average step-up margin multiples had moved toward 1.5x from 2.0x, which coincided with a period of narrowing margins up to 2018 (see "U.K. RMBS Refinance Risk Is All About The Call," published June 3, 2019). Since 2018, the proportion of bonds with step-up multiples above 1.5x initially increased, reaching a high in 2021 (see chart 3). This is likely due to the bounce back in issuance to near decade-high levels in 2021, with volumes dominated by nonbank lenders whose transactions generally attract higher spreads and the overall availability of excess spread in a deal. We believe that the proportion of tranches with multiples above 1.5x has subsequently decreased again as a higher multiple may have made some transactions no longer viable, given the rising rate environment since early 2022.

Chart 3

Considering the class A notes only, the proportion of transactions with a multiple of 2x or more has remained stable since 2021 (see chart 4). It should be noted that our sample in 2023 only includes seven transactions, so it may not be representative of the entire year; it nevertheless shows the continuing trend. We believe that the step-up margin multiple on the most senior notes is likely to drift more towards 2x in the coming year as investors price in the risk of a noncall.

Chart 4

Noncall period length and low initial spread drive step-up margin multiple

From our regression analysis, we found that the most significant variables determining the step-up margin multiple are the initial margin and the length of the noncall period. The longer the noncall period and/or the lower the initial spread, the higher the step-up margin multiple.

Our analytical approach assumes no call

We do not rate to the call date but to the final maturity date of the notes. Because there is no guarantee that a transaction will call, as part of our ratings analysis, we assume that call options are not honored. Call options are typically exercisable on quarterly payment date after the first call date. So, an issuer facing liquidity issues on the first call date may have sufficient funds six months later and exercise the call option then, meaning that calls may be delayed rather than not happen at all.

A Noncall Is Not Without Risks For Investors And Originators

Non-exercise of the call option may have the following consequences:

• Adverse selection leading to higher credit risk in the securitized mortgage pool: In other words, the best-performing loans may be repaid first, and the pool could be left exposed to tail risk with a concentration of borrowers unable to refinance and/or struggling to meet their monthly installments.
• Lower excess spread: the liabilities' margins will be higher after the step-up date, while the assets may be subject to spread compression as borrowers with loans featuring higher interest rates may be more likely to refinance sooner (e.g., at the end of their fixed interest rate period). This can result in lower--or even negative--excess spread.
• Tarnished reputation as a "repeat issuer": investors may expect the call option to be exercised at the earliest date. If originators begin not calling their transactions, investors may therefore view subsequent transactions less favorably and/or request more beneficial terms.

Idiosyncratic cases of legacy transactions

It may be especially difficult to take a view on legacy transactions' call decision. Firstly, it may not make economic sense to exercise the call if the step-up margin is lower than the margin, which would hypothetically prevail on a refinancing transaction. Secondly, the originator/issuer may no longer exist, (e.g., in the case of Lehman-sponsored transactions). Last but not least, issuers would have had plenty of time by now to exercise the call since the first call date (in most cases a decade ago or longer), and we therefore believe there is no reason why they would exercise their call now.

End Of TFSME And Call Exercise Could Boost Gross Issuance Next Year

The expiration of the Term Funding Scheme with additional incentives for SMEs (TFSME) of £173 billion (as of June 21, 2023) next year may lead originators to seek alternative refinancing channels, including RMBS, in our view. In addition, the exercise of calls on RMBS bonds (followed by a refinancing issuance) may also further boost the primary market, in our view.

Appendix

Table 1

Related Research

• European ABS And RMBS: Assessing The Credit Effects Of COVID-19, March 30, 2020
• U.K. RMBS Refinance Risk Is All About The Call, June 3, 2019