Amid an ongoing search for yield, with several potential risks on the horizon, there may be benefits to exploring opportunities outside of traditional corporate and government bonds—such as parts of the ABS universe.
The search for yield is nothing new, but it has certainly intensified in recent months as low-yielding debt continues to dominate the investment landscape. At the same time, sentiment remains somewhat muted, as a number of potential risks—from Brexit negotiations and U.S.-China trade tensions to an economic downturn—remain top of mind.
Against this backdrop, we think there can be benefits to exploring opportunities within the broad universe of securitization. One area where we see attractive value today is within certain credit segments of the asset-backed securities (ABS) market.
More than Cards and Cars
Asset-backed securities, which fall under the broader umbrella of securitized products and structured credit, refer to bonds that are collateralized, or backed, by pools of underlying assets—ranging from student loans to aircraft leases to credit card receivables. The creation of an asset-backed security begins with the formation of a special purpose vehicle (SPV). The SPV purchases a pool of assets, such as a group of student loans or aircraft leases, and then issues debt (ABS bonds) to fund those purchases. In the case of aviation, the SPV owns the planes, and the lease payments from the planes support the bond cash flows.
Today’s ABS market is much more expansive than a decade ago, having grown and evolved into what is now a roughly $850 billion market—in fact, ABS is one of the few asset classes that has had consistent positive net issuance (positive net growth) over the past few years. More issuers are seeking financing in the ABS market, many of which investors may already have familiarity with from corporate bonds or other markets. There are also more dealers participating in the primary and secondary markets. As the assets within the securitized market have expanded and dealer participation has increased, more investors have entered the market as well, generally leading to increased liquidity in commercial and select consumer sectors.
The depth of the ABS market is no longer limited to credit cards and prime auto loans. While those sectors still account for a significant portion—just under half of all outstanding ABS deals1—the market is very diverse, spanning sectors from student loans to aviation leases to franchise receivables, where issuers include household names like Domino’s Pizza and Dunkin’ Donuts. Given its significant consumer exposure, the asset class, when considered as part of a broader investment grade or high yield allocation, can offer diversification of risk and, more specifically, diversification away from idiosyncratic corporate risk.
ABS SECTORS EX. PRIME AUTO & CREDIT CARDS
SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF SEPTEMBER 30, 2019. DATA DOES NOT SHOW INDUSTRIES THAT MAKE UP <1% OF THE INDEX.
Attractive Risk-Adjusted Returns Over Time
ABS has demonstrated resilience in response to market volatility over time, another potential benefit of including the asset class in broader investment grade and high yield allocations. For instance, in December 2018, amid macro turbulence, corporate credit experienced widespread volatility, with spreads widening across IG corporates, high yield and collateralized loan obligations (CLOs). ABS spreads, on the other hand, remained relatively resilient—widening, but to a much lesser extent.
In addition to the positive performance in 2018 and year-to-date 2019, ABS has also performed well longer-term, particularly on a risk-adjusted basis. Looking back over a five-year period, ABS (excluding credit cards and prime autos) have delivered attractive risk-adjusted returns relative to broader fixed income markets.2
SECURITIZED CREDIT 5-YEAR EXCESS RETURN VS. VOLATILITY
SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF JUNE 30, 2019. *RATIO IS A MEASURE OF EXCESS OR SPREAD RETURN (STRIPPING OUT TREASURY) VS. VOLATILITY
ABS represents one of the most effective ways for investors to complement corporate risk by gaining direct exposure to the consumer. While there are concerns today about the potential for future economic weakness—and at absolute levels, consumer debt has increased over the last decade—debt service coverage for consumers, or the cost to carry that debt, actually looks fairly reasonable, particularly in the context of lower interest rates. And this is at a time when many high-rated corporates have taken on additional leverage. Further, performance across auto, credit card and student loans, as well as residential assets, is relatively stable—defaults, delinquency and losses appear to be measured, in our view, and with a few exceptions remain well-below financial crisis levels.
It is also worth noting that from a structural standpoint, asset-backed securities are well-equipped to withstand adverse market conditions. Similar to other securitizations, ABS typically offers seniority of claim over cash flows within bankruptcy-remote vehicles, as well as other embedded structural protections. Risk retention, for instance, can align interests by requiring underwriters to maintain skin-in-the-game. In addition, the capital structure can afford the flexibility to invest up and down the ratings spectrum based on risk appetite, relative value shifts and changes in market conditions. The structure of ABS also has the potential to provide natural deleveraging by virtue of self-amortizing (liquidating) assets (e.g. auto loan amortization). Historically, these protections have allowed even highly rated, AAA ABS to maintain their rating, even through a corporate bankruptcy.
Accessing the Opportunity
While we continue to see opportunities across the fixed income markets, there are a number of potential risks on the horizon that could introduce volatility in the coming months. In this environment, we think it makes sense for investors to consider a broad asset multi-credit allocation. One way to do this is through investment grade and high yield strategies that offer exposure to market segments such as asset-backed securities. In addition to providing considerable diversification and the potential for attractive risk-adjusted returns, ABS offers an opportunity for active management across asset classes and can give managers the flexibility to allocate away from areas that look less attractive at any given time.
1. Source: SIFMA. As of June 30, 2019. Excludes $776 billion in structured CDO securities.
2. Source: Bank of America Merrill Lynch. As of September 30, 2019.