5 min read 26 Aug 21
Inflation has been a huge talking point this year, with many investors struggling to assess whether the expected global economic recovery will lead to sustained rises in consumer prices and how this might affect policy decisions. Major central banks have loosened their inflation targets to give room to their economies to ‘run hot’. However, the path ahead is still unclear, with some analysts pointing to slowing growth and slack in labour markets, while others believe central banks will be forced to raise interest rates.
Amid this uncertainty, floating rate instruments such as European asset-backed securities (ABS) have offered some much needed protection, outperforming major bond markets in the first half of 2021.
Past performance is not a guide to future performance.
While low duration is part of the story, investor interest has been underpinned by solid fundamentals, including strong collateral performance throughout the pandemic and enhanced structural protections for new issues, as well as a sizeable spread premium over corporate bonds.
Within collateral pools, delinquencies, defaults and losses have all been lower than expected at the start of the pandemic. Meanwhile, credit rating downgrades have been concentrated in a small number of sectors, such as hospitality1. Arguably, the biggest influence on collateral performance has been the speed and scale of government support, but typically strong underwriting practices in Europe have also played a role.
Residential mortgage-backed securities (RMBS) pools have held up over the past 12 months, notably in the UK, which is by far Europe’s largest RMBS market. The introduction of mortgage payment holidays last year presented some cashflow risks, but the number of borrowers accessing the scheme has reduced significantly.
Our own analysis suggests that UK prime borrower payment holidays peaked at c.25% of outstanding mortgages in mid-2020 and fell sharply thereafter . Since November, only c.2% of prime borrowers have used deferrals at any given time. Meanwhile, serious mortgage arrears (those with payments 90+ days overdue) were relatively stable at c.0.5% throughout 2020, with only c.2% of those using payment holidays entering serious arrears once they exited the scheme2.
We believe delinquencies could rise modestly in the second half of 2021 and in 2022, as the end of support schemes such as furlough may lead to higher unemployment. However, we do not expect a meaningful increase in mortgage defaults in the UK or continental Europe, due partly to major improvements in underwriting practices and deal structures over the past decade.
Bond yields have collapsed over the past year or so, and credit spreads are now at historically tight levels. While European ABS spreads have also recovered, they remain much wider than spreads on corporate bonds, including those with lower credit ratings.
In AAA European CLOs, spreads at the end of June 2021 offered an average pick-up of c.40 bps over European investment grade credit, which has an average rating of A-. Meanwhile, AAA UK non-conforming ABS typically traded at spreads lower than 70 bps compared to 86 bps for A rated corporate bonds, despite being two rating bands higher.
Looking ahead, we believe senior and high-grade European CLOs could present potentially attractive opportunities, as spreads have tightened less than in RMBS markets. In fact, CLO spreads widened in the second quarter (Q2) of 2021 for what we believe were technical rather than fundamental reasons, including elevated supply; depleted cash balances of large buyers in Q1; and previously overstretched valuations compared to investment grade mezzanine tranches. As such, we began to reallocate some of our capital to high-grade CLOs in late June and early July 2021.
In our view, the relatively flat European ABS duration curve makes shorter-dated refinancings and secondary market opportunities more compelling than new deals, which generally have longer durations and limited spread pick-ups.
The overall technical backdrop suggests a modest net supply of European ABS at best in the period ahead. New issuance of €49.7bn in the first half of 2021 indicates that volumes are still recovering from the impact of Covid-193, and some refinancings are taking place outside of public markets. Unless we experience another black swan event, these factors, combined with improved economic fundamentals and robust deal structures, should continue to provide stability for European ABS spreads.
1 S&P Global, European Leveraged Finance Conference, June 2021
2 Moody’s, Sector Comment: Covered Bonds and RMBS – UK, March 2021
3 BofA Global Research, European SF Weekly, 21 June 2021
The views expressed in this document should not be taken as a recommendation, advice or forecast.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.