3 min read 14 Sep 23
European ABS has traded at some of the widest levels relative to corporate bonds that we have ever seen (see chart below). Traditionally one of the largest buyers of European ABS, the UK (DB) pension community raised very significant amounts of liquidity in the asset class in the aftermath of the government’s ‘mini-budget’ in September 2022. These selling volumes drove spreads to some of the widest levels in the post-GFC era and remain elevated today. This combined with floating-rate coupons that have steadily increased with the rate-hiking cycle, ensure that all-in-yields for one of the most defensive and credit resilient fixed income assets are extremely attractive, in our view.
The high spread charges attributed to ABS following the implementation of Solvency II in January 2016 resulted in significant retrenchment from the market from European insurance investors and an asset class which historically formed a strategic part of balance sheet investment was sold in high volume. This seismic demand shift enabled European pension schemes, endowments, sovereign wealth funds and some wholesale asset owners to enjoy compelling yield levels, typically offering a pick up versus an equivalently rated corporate bond.
Recently however, insurance companies across Europe have started to re-introduce securitisations into their portfolios in part due to an improving regulatory landscape (notably the introduction of Simple, Transparent and Standardised framework ‘STS’), and in part they want and need to add asset class diversification and portfolio yield.
This has been particularly pronounced in the past year due to a combination of:
The changing appetite of a significant buyer base combined with the potential for highly compelling risk and returns metrics allow for an investment opportunity for investors who are able to purchase these assets.
The possible benefits of ABS for insurers are:
But where do these fit in the context of the balance sheet?
For insurers who have excess cash on their balance sheets, the liquidity and seniority of senior ABS is a suitable asset class to optimise this position, in our opinion. Focus on making cash work harder has sharpened since inflationary numbers have risen and investors need additional yield to make up the shortfall between cash rates and inflation.
At the time of writing, a portfolio of diversified AAA rated, short duration, ABS offering daily liquidity is yielding close to 7% gross1.
By thinking more holistically about cash holdings and splitting the requirement between immediate needs and when the need for drawing on those deposits are longer, investors can put themselves in a position to close the ‘inflation/cash’ gap.
For those insurers who are able to take a little bit more spread risk in their investment portfolio, ABS has offered compelling yields all the way down the investment grade capital stack, in our view. These assets are defensive, secured on high-quality physical assets, offer investment diversification and are well suited to inflationary economic environments and therefore allow for portfolio benefits outside yield.
The assets are extremely credit resilient with AAA RMBS bonds for instance being able to withstand extreme economic stresses before they even begin to take a principal loss. In the below example of a typical UK RMBS transaction, we show how a 40% fall in house prices (with no recovery) and 70% of the underlying borrowers need to default on their mortgage before the first £1 of loss incurred. These are circumstances far beyond the scale of any previous economic downturn and demonstrate how robust and deserving these bonds are of their AAA-rating.
ABS transactions have also exhibited a strong bias towards rating upgrades rather than downgrades. ABS credit metrics tend to improve over time as people pay down their mortgages or loans and LTVs decrease. These cashflows from the underlying borrowers de-lever the transaction structure, increasing the credit protection available to bond holders. This should appeal to insurers who will typically want to minimise credit risk.
In summary, September 2022 caused a fundamental shift in the UK DB pensions market and crucially demand dynamics for certain asset classes both in the short and long term, making ABS a potentially attractive option for insurers seeking to redeploy cash while improving portfolio yield. For portfolios that are designed to beat cash, while seeking to remain very liquid and defensive, we believe it is desirable to focus on the AAA-rated ABS, since lower rated instruments can add a lot of volatility during turbulent periods such as the LDI crisis.
The risks of losses on the underlying loans are a key concern for ABS bond holders. However, investors can seek to mitigate these risks by focusing on diversified pools with lower individual borrower concentrations; partnering with established issuers with a track record of lending through the cycle; and meticulously stress testing portfolios to facilitate a high probability of withstanding prolonged periods of economic weakness.
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. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.