LCP clarity:
ABS offers investors a yield currently around 1% higher than is available on investment grade bonds for similar risk.
LCP insight:
If you have a large portfolio of cash collateral (eg backing an LDI portfolio), consider whether you can enhance its yield by investing in ABS.
The asset-backed securities (ABS) market is young in comparison to most asset markets, having been born towards the end of the 1980s. It had a quiet childhood, but in its late teens experienced the perils of over-exuberance when the global financial crisis arrived in 2007. Wiser for the experience, and with some additional regulation to keep it in check, the ABS market has now matured into a responsible adult, offering a low-risk and reliable source of investment returns.
Why does the ABS market exist?
At some point in our lives, most of us have taken out loans to buy education (student loans), houses (mortgages), cars, or simple credit card debt - payable to the bank that provided the loan.
What if the bank wanted to sell the loan to an institutional investor such as a pension fund? The small size of each loan would make this impractical. This is where ‘securitisation’ comes in – whereby illiquid assets in large volumes (such as a collection of mortgages) are pooled together in a special purpose vehicle. This special purpose vehicle converts the underlying assets into tranches of tradeable securities with different risk ratings, which can be bought and sold by investors rather like traditional equity and bond assets.
The process of securitisation is a way for banks to free up capital to provide further lending, by packaging their portfolios of, for example, student loans and moving them off their balance sheet into the special purpose vehicle.
What are the main types of ABS assets?
1. Consumer borrowing, primarily residential mortgages (known as RMBS) but including other borrowing such as credit card and car loans
2. Commercial mortgage backed securities (CMBS)
3. Collateralised loan obligations (CLOs - pools of corporate loans)
How big is the market?
The US and European markets in securitised assets amount to about $4 trillion. By way of comparison, the US and European investment grade corporate bond markets are around twice the size. Both markets are split broadly 3:1 in favour of the US. So, the securitised market is large although, just as in corporate bond markets, liquidity can be variable. It can be accessed via a segregated account (for large mandates) or via a pooled fund.
What returns does it offer?
Assets are ‘floating rate’, so for example Sterling investors will expect to earn LIBOR (or SONIA from the end of this year) plus a credit spread depending on the level of risk borne.
A current advantage of ABS over conventional corporate bonds is that they are not part of the European Central Bank's asset purchase programme, so their yields remain attractive relative to investment grade corporate bonds, with a yield pick-up of around 1.0% at June 2021 (source: Aegon Asset Management).
Investors in lower rated ABS tranches may expect significantly higher yields, but the returns are at greater risk from defaults.
What are the main risks?
Investing in a pool of loans, securitised or otherwise, carries the risk of default on the underlying loans. However, because ABS vehicles are tranched into different levels of risk, investors can choose what level of risk (and hence yield) to take, as illustrated below.
Holders of lower rated tranches can only be repaid when the more senior tranches have been repaid in full.
This process provides security (or ‘credit enhancement’) to investors in the higher-rated tranches, with the first losses being taken by the equity investors.
Whilst actual default losses are very low (see next section), liquidity does vary, and market prices can be affected by investor sentiment. For example, highly rated ABS funds fell by as much as 5% as the Covid-19 crisis emerged in Q1 2020 and investor flows were negative, but they recovered to finish up over 2020 as a whole.
What went wrong in the global financial crisis?
ABS asset pools are only as good as their underlying asset collateral. In the US, banks commonly made mortgage loans to individuals who had no ability to repay them, and, unlike in Europe, when a US borrower defaulted on their mortgage they could simply hand the keys to their house back to the bank and walk away. Vast numbers of these ‘sub-prime’ loans moved off bank balance sheets into ABS vehicles. With little visibility of the extent of the risks within ABS asset pools, a crisis ensued as investors sought to distance themselves from the underlying default risks.
Unfortunately, this episode severely tarnished the reputation of the ABS market. Yet US sub-prime was only one small area of an otherwise highly successful and functioning market.
According to Fitch, realised losses across the US and European securitised credit markets were around 6% and 1% respectively of the assets held in structured vehicles between 2000 and 2020. Remember that losses hit the equity investors, then the lower rated tranches, before reaching the most highly rated tranches - so losses in the upper tranches are rare indeed.
In fact, in European ABS backed by residential prime and buy-to-let mortgage markets, there has never been a loss recorded in the senior (AAA/AA) tranches.
Is it ESG-friendly?
Not fully, but the trend is in the right direction. Whilst there is data available to assess existing ABS assets from an ESG perspective (eg emissions data on car loan pools, energy efficiency of commercial buildings backed by mortgages) only a handful of ABS structures have been created with specific responsible credentials. The first-ever social RMBS was created in early 2021, backed by a pool of UK mortgages designed to offer UN Sustainable Development Goals-aligned accessibility to housing for areas of the population less well served by traditional mortgage products, such as the elderly, the self-employed and younger borrowers. The lack of supply can be put down to a lack of specific green collateral (eg loans on fleets of purely electric cars, loans to update energy-inefficient housing) but this is an area of the market that is surely destined to grow.
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