Last week the Bank of England (BofE) signaled that it might increase interest rates in the third quarter to get a hold of inflation.

The structural support in U.K. RMBS deals means that the BofE move will likely not have a broad impact on market performance, Unicredit analysts said.

According to published reports, the market's expectations on the future development of U.K. base rates are that interest rates will increase by a maximum of 50 basis points this year and by a maximum of another 75 basis points next year.

Unicredit analysts said that increasing rates can lead to higher redemptions and refinancing activity in U.K. prime RMBS mortgage pools.

"In a reverting interest rate cycle CPRs will increase once again, even though such an impact will follow with a time lag and is unlikely to broadly materialize by just one rate hike," analysts said. "With further rate hikes by next year, a CPR impact could be felt, lowering the actual weighted average life (WAL) on U.K. RMBS portfolios."

For prime RMBS, increasing CPRs would be price positive and supportive of spread in the medium term. However, for U.K. nonconforming and U.K. buy-to-let (BTL) RMBS, interest rate rises could cause the average debt service coverage ratio (DSCR) of BTL mortgage borrowers to decline by about 40% by the end of 2012.  

A report on buy-to-let RMBS published by Standard & Poor's this month said that record low interest rates and steady rents have driven the debt servicing ability of mortgage borrowers to sound levels, given that roughly 90% of BTL mortgage loans outstanding are interest-only loans in the U.K.

However, a decline in DSCR means that these borrowers will have less of a financial cushion to cover mortgage payments.

"Furthermore, even relatively mild house price declines over the next two years could place more than 30% of BTL borrowers in negative equity, reducing their financial flexibility and thus risking a rise in arrears," S&P said in the report.

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