(September 9, 2013) – Asset-backed securities (ABSs) are back on investors’ menus, and with further issuance predicted over the next 12 months it could well be here to stay.
Having suffered—and inflicted some large losses—during 2007 and 2008, largely due to leverage issues and poor collateral choices, ABSs have slowly but surely found their way back onto investors’ portfolios in the past 12 months.
There are several drivers for this—the push for high yield in a low-returning environment, the need for a diversifier in alternative and fixed income buckets, and the desire for the interest rate protection provided by European floating rate notes.
In addition, investors have seen that the default rates during the financial crisis, particularly for European ABSs, were not as bad as they had feared.
Research published by Standard & Poor’s in April this year showed from mid-2007 to the end of 2012, the default rate for European ABSs was just 1.37%. US paper by comparison saw 16.76% default.
Last month, aiCIO reported that 38 Dutch pension funds had begun investing in mortgages, which are often the main loan products that make up ABSs. PME currently invests €2.7 billion in Dutch residential mortgages, and ABP has €6.5 billion in domestic mortgage securities, although most of that is in legacy funds from the days when ABP itself provided mortgages.
However, issuance of new ABS paper is currently falling, and the spreads on existing paper is expected to tighten further—having already gone through a serious tightening in 2012. So will we see more pension funds and other institutional investors piling into ABSs over the coming months?
The consultants are unconvinced of their clients having more than a passing interest in the sector. Pete Drewienkiewicz, head of manager research at Redington, says he hadn’t seen significant interest in ABSs since the aforementioned spread tightening last year.
“Although we believe that spreads in many areas of the ABS market still overcompensate for default risk, the spreads available on investment-grade ABS no longer meet our clients’ strategic needs,” he says.
“Many clients still have concerns over certain areas of the ABS space, particularly around double securitisations. But we have had clients investing in the space since 2009 who have experience super-normal returns as a result of their early allocation to the asset class.”
Drewienkiewicz believes further tightening will occur in ABS spreads, and any higher move in UK short term rates could put residential mortgage-backed securities (RMBS) under pressure.
Aon Hewitt partner Tim Giles said the interest level from his clients was decidedly mixed. While some clients are still nervous because of the dramatic falls ABS saw during the beginning of the financial crisis, others are more concerned with obtaining better yields, and were able to ride out liquidity problems if they arise.
“You need to make sure you’ve got a good handle on the quality of the assets and how it might suffer if a market crisis hits,” Giles says.
“Will you see great returns from the sector in the future? Probably not, but it’s still got a place in the portfolio, as long as you can cope with the possible lack of liquidity.”
Where investors were interested in ABS funds, Aon Hewitt’s larger clients are using direct mandates, Giles said. But what he is seeing far more of was investors adding them to general fixed income mandates that are trying to reach Libor (London Interbank Offer Rate) +2% or Libor +3%.
Speaking to the asset managers however, provides a whole different perspective. Many of them cited rising interest levels, particularly from pension funds and insurers, and said that supply and not demand was the problem.
M&G Investments has been one of the most active players in the European ABS space for around 15 years, and currently has €18 billion under management in the asset class. Its ABS opportunity funds, launched in 2008, have had no defaults since inception.
Portfolio manager James King tells aiCIO that good quality European ABSs were increasingly being seen as a defensive alterative to corporates and financials, yet frequently offer higher yields.
“ABS offers interesting investment diversification for investors, and also allows access to discrete pools of credit, such as consumer mortgages or loans to small and medium enterprises,” he says.
“Liquidity, especially within consumer ABS, remains good and the floating rate nature of the product provides inherent protection from rising interest rates.”
This last benefit means much of the US commercial mortgaged-backed securities paper has been ignored by the investor market, given the majority is held at a fixed-rate.
There’s still a major headline-hangover with US paper too—most European investors still won’t touch RMBS with a proverbial barge pole, and demand limits on US collateralised debt and collateralised loans obligations (CLOs).
Having said that, CLO issuance has increased more recently, with spreads becoming comparable to European CLOs for the first time in years, according to Henderson’s Ed Panek, head of ABS investment at Henderson Global Investors.
“It’s a watching brief on the US ABS market for now,” he says.
There may be more of an appetite from US investors as the economy improves, but for cautious CIOs the spectre of that 16.78% default rate and the headlines over subprime mortgages are still too scary to contemplate.
Story Continues…Concerns to Consider
Future regulation is the biggest concern for the sector in many managers’ view, particularly the treatment of ABSs under Solvency II. M&G’s King believes the harsh treatment of ABSs under the regime has been well-flagged for several years however, and that insurers have largely adjusted their portfolios and buying patterns already.
While acknowledging that capacity is dramatically lower than the asset classes’ hey-day in the mid-2000s—it is estimated that there’s €700 billion of European ABS outstanding today compared to €2 trillion at its peak—King argues that €700 billion means it isn’t a small asset class.
Large proportions of that paper is kept locked away with long-term holders already though, and without meaningful new issuances, new investor numbers will shrink, forcing spreads to tighten further.
Capacity was a top concern with many other asset managers. Henderson Global Investors’ Panek blamed government agencies’ liquidity measures for dampening enthusiasm for new issuances on the market.
“It’s not just the Funding for Lending Scheme (FLS) in the UK – the European Central Banks and the Bank of England have made alternative funding sources extremely cheap,” he says.
“In addition, there’s been a very slow pace of origination of primary assets. The net lending of the UK shows lending has barely broken zero. There’s not a lot of growth that needs to be funded, and what little there is is being financed through alternative means which are more attractive to a bank.”
Matthias Wildhaber, portfolio manager of the Julius Baer ABS Fund, Swiss & Global, also noted that while there had been some new issuance in the senior commercial mortgage-backed securities too, large investors looking to place big trades are struggling.
“Investing a few hundred million is difficult at the moment,” he says. “Even with your Dutch mortgage example, there’s not so many issuances. So far the large investors have had to diversify: it’s difficult even to buy a €10 million block of paper.”
While banks are beginning to sell some of their portfolios, the good quality paper is only offered to the market in good times as the banks try to sell at as close to par as possible, he adds.
“If spreads move to more reasonable levels, you’ll see more issuance,” he predicts.
To boost issuance, a few other things need to happen too. The short-term liquidity boosting policies need to be phased out, and the banks need to be convinced to sell off more of their portfolios.
The market has seen some new issuances recently, although not anywhere near on the same scale are pre-2007. Where big issuers might have made three or four deals on the market a year before, most are making just one a year today.
“Even with the FLS scheme going, you’re still seeing Santander and Lloyds coming to market with deals, to keep themselves at the front of investors’ minds,” says Panek.
The general improvement of the economy will also help, according to Andrew Jackson, managing director of ABS investments at HSBC Global Asset Management.
“House prices are improving, which means things are getting better,” he says. “If the fundamentals and the technical continue to improve, and the yield continues to be more attractive than fixed income assets, ABS will be popular.”
Finalisation on the regulatory issues around ABS from a Solvency II, Basel III, and the Alternative Investment Fund Management Directive will also lead to an issuance pick-up, as investors and managers will be able to plan better, he adds.
Some managers are without any doubt that issuance will increase. Olivier LeBleu, head of non-US distribution for Old Mutual Asset Management, strongly believes issuance will increase “come hell or high water” because investor demand will increase and Europe’s banks will seek to offload assets as they become more liquid.
“CMBSs are likely to see a rise in interest levels—even the biggest distressed areas in Europe need real estate, so that’s where they’ll start to look for securitisation, to offload the risk,” he says.
“A rise in issuance needs to happen. There was enough on the market a year ago for you to get a solid A rating ABS with a return of 8%—that’s no longer possible because the paper’s been ‘bid up’.”
Risks to Manage
ABS ratings are substantially harder to obtain than in the pre-crisis years. One of the criticisms of ABSs during the crisis was that many of the securities has been mis-rated, leading CIOs to steer away from them. Increasingly today, managers are performing their own due diligence on collateral assets and working harder on the covenant structures.
“When ABSs went wrong, it was because the collateral quality was poor, not just because of issues with the leveraging of them. The economy dipped so quickly that everything went bad all at once,” said Old Mutual Asset Management’s LeBleu.
“ABSs’ recovery has been good, and there’s been a greater recovery still in collateral calling. As ratings and quality improved, it’s led to the legacy paper being pretty much fully bid.
“The next thing to watch out for will be duration. Duration matters: the tapering tantrum has led to people needing to look at the impact of quantitative easing on long-term rates.”
Other than the regulatory question marks noted earlier, all managers also warned of the danger of market shocks on the ABS market.
The headline risk that would come with Spanish or Portuguese economic failures would mean the poorer collateral assets would be exposed, causing a knock-on effect on the ABS market as a whole. If you can’t handle the liquidity risk, get out of the ABS kitchen, was the message from most.
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