5 min read 15 Dec 22
At the start of 2022 there were a number of headline risks that were likely to materialise as the year progressed. Principally, the need for tighter monetary policy to tackle persistently high inflation as the world dealt with supply bottlenecks in the aftermath of the pandemic. A number of unforeseen shocks, namely the Russian invasion of Ukraine and subsequent food and energy price rises, followed by the LDI pension crisis, have dominated the narrative. These events ensured that 2022 was punctuated by bouts of volatility that have proved extremely challenging for risk assets.
Major economies now find themselves much further along the path to monetary policy normalisation than would perhaps otherwise be the case, and the knock-on impact for valuations has been stark. European ABS has, however, outperformed many of its peers given the floating rate nature of the universe.
Despite the challenging start to the year in broader credit and equities, the floating rate nature of the European ABS universe ensured that the sector got off to a fast start with a healthy pipeline of primary market transactions and strong investor appetite. However, the momentum could not be sustained as weakness in broader markets and the Russian invasion of Ukraine brought the primary market to a standstill in the second quarter.
While we saw a recovery in both spreads and primary market volumes in late summer, this period of relative stability would soon be upended by the disastrous “mini-budget” from the UK Government that brought turmoil to the gilt market and sent pension funds scrambling for liquidity to cover collateral calls in their LDI strategies.
In the days and weeks immediately following the budget, trading volumes in the ABS market became extremely elevated, dwarfing the volumes seen even during March 2020 (see chart below). An unprecedented £10 billion+1 in secondary market selling volume from motivated sellers drove spreads significantly wider across the capital structure. While volumes were heavily focused on AAA and AA-rated European CLOs and UK RMBS, other sectors including those in continental Europe succumbed to the volatile trading conditions. Whilst we have observed significant spread widening as a result, it is worth highlighting that, in our view, ABS liquidity held up well compared to other fixed income markets.
It is clear that the volatile backdrop has inhibited the ability of issuers and arrangers to bring transactions to the market. Year-to-date distributed ABS issuance in Europe of around €52 billion2 is nearly 25% below the post-GFC average of €66.5 billion. A very significant proportion of the transactions that did come to market have been placed in “club style” syndication processes where key market participants such as M&G anchor transactions to limit issuers’ execution risk.
The outlook for supply into 2023 is likely to improve, but the trend for overall negative net supply is likely to persist. In the Eurozone, where volumes in 2022 have been particularly subdued, the roll off of long-term central bank funding options should encourage banks to return to the securitisation market and bolster particularly the supply of STS designated transactions. In the UK, rising mortgage rates will have an impact on house prices and likely result in lower mortgage origination and lower issuance volumes for the non-bank issuers that dominate the UK RMBS market.
The impact on spreads of the volatility we have seen this year has been pronounced, with the impact felt across sectors and right throughout the capital structure. By way of example, AAA UK RMBS spreads have widened from Sonia +70bps to Sonia +200bps. When this is combined with the increase in benchmark rates from central bank attempts to tackle inflation, all-in yields are now higher than they have been at any time since the tail end of the financial crisis.
In our view, the yields on offer combined with the structural resilience of ABS transactions makes them an extremely compelling investment proposition. While we can expect fundamental performance to deteriorate in the coming months there are a number of reasons why we believe these transactions are, in the main, well placed to come through this period in good order.
It is first worth noting that we are starting from a very low base in terms of historic mortgage delinquency numbers and this coupled with a strong period of house price appreciation, a robust labour market, lower LTVs and improved underwriting standards since the GFC, provide comfort as to the asset class's ability to weather the economic headwinds.
Also, despite increases in borrowing costs, household interest payments as a percentage of income are lower than the long run average. Indeed only as base rates approach 5% in the UK do household interest payments return to their long term trend level as a percentage of income.
RMBS remains the most resilient sector of the European ABS market with borrowers likely to default on multiple unsecured obligations before failing to pay their mortgage. There is also evidence that mortgage borrowers in UK RMBS pools are skewed towards borrowers from higher income brackets, who are perhaps better able to absorb the rising cost of living. The data below shows that as little as 12.9% of borrowers in the UK non-conforming universe fall into the lowest four income deciles.
While we expect transactions to be resilient it is inevitable that performance based tiering will increase and therefore it is vitally important to have the resources to look at the loan level data and assess the likely characteristics that will drive performance trends. In RMBS, this will likely include the percentage of self-employed borrowers, LTVs, when the collateral was originated and when the loan's initial fixed rate term ends.
The recent bout of spread widening has also shone a light on the potential for extension risk in transactions where the step-up and call feature is not punitive enough to make the call economics certain. While only one UK RMBS transaction in 2022 failed to meet its call date, and spread normalisation should begin to mitigate the risk in 2023, it should remain a key focus for investors to avoid transactions where bonds can suddenly price to an extension scenario.
While ABS performance has fared very well in comparison to the majority of the fixed income universe, we believe forward looking returns are also compelling. The spread widening and increase in all-in-yields via the index component of bond coupons makes them potentially very attractive from a risk return perspective.
In our view, the most recent liquidity driven episode has pushed valuations on high quality, well rated, defensive senior and investment grade bonds to extremely attractive levels, this is not a reflection of a fundamental re-appraisal of ABS credit risk, but rather simply the cost of accessing liquidity on a significant scale in extremely short order. Our firm view is that this is a technical, liquidity driven sell-off and as such it can potentially be exploited by investors that can take a longer term view.
1 M&G, JPM International ABS BWIC Tracker as at 28 November 2022, Citi Velocity daily BWIC data.
2 M&G, JPM International ABS Weekly Datasheet 25 November 2022, GlobalLoanStats Charts EU, 14 November 2022.
The value and income from a fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.