UK private bank Kleinwort Benson is seizing what it views as a once in a lifetime opportunity to invest in US mortgage-backed securities, launching a fund which the bank says offers investors the potential to make a huge potential return.

Kleinwort Benson believes that the right approach to bond markets currently is a barbell approach; Government debt offering safety, high grade senior tranches of corporate debt (industrials) offering a low yield, with mortgage-backed securities offering the element of high yield to boost income for the opportunistic investor.

The bank views that the market is assuming a level of meltdown that is increasingly unlikely to occur and that there are opportunities available to invest in high-quality MBS at deep discounts.

“These bonds are currently pricing in more than a 1930s level of default and loss of value, and we believe that the US government won’t let that happen,” said Natalie Merrens, Kleinwort’s head of Product Advisory.

Senior-tier US mortgage backed securities are currently trading at discounts of between 40 to 70 per cent and yielding 18 to 22 per cent on a base case scenario. As such, investors in the fund could gain a high annual income along with the potential to make a significant capital return, should the pricing of these bonds mature closer to par value, said Ms Merrens.

The bonds will, of course, be volatile, but as people default or remortgage their properties, money comes back to the investor – and since the fund will be invested only in the top tranche of securities, the fund’s investors will be paid first, she said. 

The fund is a joint venture with US investment house Colchis, which is run by Nick Krisnich. Until 2005 Mr Krisnich had been chief risk officer at Countrywide, the US mortgage lending giant, but he left this role in 2005 due to his concerns about what he considered excessive risk-taking.

Mr Krisnich has utilised his experience in assessing the US housing market to develop a proprietary screening system through which to select mortgage-backed securities. Mr Krisnich, Kleinwort believes, has a unique insight into the US housing market and through his screening system brings to the fund the highest level of MBS risk management the bank has seen.

This system is extremely rigorous, said Ms Merrens, weighting an array of information on both the local property market and the individual mortgage holders within the bond. This “bottom up” assessment of homeowners’ credit rating, job security, loan history and other circumstances is the antithesis of simply buying a bond on the strength of it being labelled AAA, she said.

Ms Merrens explained that the “natural” buyers of mortgage-backed securities, hedge funds and investment banks, either cannot, or will not, buy these bonds at the moment, leaving Kleinwort in a particularly strong position.

Given the role of US mortgage-backed securities in the creation of the credit crisis, it would be understandable if clients were wary of such an investment. Kleinwort is however finding that its clients, many of whom have a background in banking, are reacting very positively to the fund as a means to play the distressed market.  

The fund’s investment process appeals to investors because it is “simple, clear and rigorous”, said Ms Merrens, adding that, “it’s the detail they like.” Furthermore, at a time when transparency is high on the agenda, investors are attracted to an investment which is based on a tangible underlying asset which is easily understood, she said.

The fund will target short-dated mortgage-backed securities which originated between 2005-2006 and will have a maximum lifespan of seven years.