The future is bright for European ABS

Fixed income investors have steadily been exploring alternative allocations within their portfolios. Seeking greater return diversification, areas such as structured credit have come into focus. With a variety of options available, perhaps one of the most compelling are asset backed securities (ABS). This is a component within the structured credit universe which investors are increasingly looking towards but may not fully appreciate the breadth of benefits it can offer. 

Whilst not a new area of credit, ABS may not be as familiar an investment destination as other more traditional fixed income options. It is therefore worthwhile to recap what exactly ABS are and how they are structured.

What are asset-backed securities?

ABS is quite a broad term and covers a diverse spread of assets such as residential mortgages, consumer loans, credit card receivables etc. The value to investors is that ABS facilitates entry to parts of the investment universe that may otherwise be difficult to access. This in itself can provide certain portfolio diversification benefits.

Typical ABS asset pools

Depending on the assets, the structure of ABS can vary: residential mortgages will typically be packaged up as residential mortgage-backed securities (RMBS), whilst corporate loans will typically be packaged to form a collateralised loan obligations (CLOs).

Once the pool of these assets grows to a certain overall size, typically €300-500 million, they are moved into a bankruptcy remote special purpose vehicle (SPV). This structure is important as it removes the credit linkage to the originating bank. 

ABS securitisation process

Investor optionality

Once the SPV is formed, the SPV can issue notes of varying credit quality – investors can choose where to invest in the capital structure depending on their risk appetite, time horizon and liquidity needs. Ratings on these notes start from AAA down to more junior tranches. Any losses from the underlying assets are taken first by the equity tranche and only thereafter does exposure migrate up to the high yield tranches and eventually to the senior and investment grade part of the structure. 

“ABS is a highly defensive and relatively safe option.”
 

We believe European ABS is a highly defensive and relatively safe option. Indeed, particularly when investing within the investment grade part of the structure, the probability of being exposed to a principal loss is remote.

ABS issuance

In 2024, both the size and variety of European ABS and CLO issuance was positive and points to a growth trajectory we believe will continue in 2025 and beyond. The reason for this confidence lies in the catalyst for increased issuance recently. We believe heightened issuance levels reflect the end of the COVID era’s cheap, central back funding schemes with the consequence that banks can no longer fund themselves as cheaply as before via central bank facilities. As a result, they are now consistently looking to the ABS market as a source of funding for their asset portfolios. For this reason, we are confident the European ABS market will continue to rise strongly. 

There are different trends we have observed in terms of new issuance:

1. CLO market: Leveraged loan ABS transactions – this has been a very vibrant new issuance market recently.
   
   
2. UK market: Very strong, particularly with residential mortgages.
   
   
3. Continental market: Variety of jurisdictions, asset classes and banks issuing into the ABS market. 

With regards to the continental markets, this broader spread of participants has marked a big change as traditionally the European Central Bank (ECB) was the buyer of continental ABS with a large volume of issuance not reaching the public market. This is now changing as we have a much larger range of investors which are now investing in the ABS market. This has also meant liquidity within the European ABS market has continued to improve.

“A much larger range of investors are now investing in the ABS market”

Is ABS really a defensive asset class?

We strongly believe that ABS is a defensive investment choice. By way of illustration, we can consider a typical AA-rated UK RMBS ABS bond. In a mortgage portfolio, ABS bonds are backed by a pool of residential mortgages which amortise over time. As mortgage payments are received, the most senior tranche within the ABS structure is repaid, then high yield, and eventually down to the equity tranche. When analysing the potential of loss, credit analysis looks to calculate what scenario would need to occur in order for the AA tranche to absorb the first penny of loss. 

With this example, for this loss to occur, more than 50% of borrowers would have to default on their mortgage, in addition to a 40% collapse in house prices. Even during the global financial crisis (GFC), UK residential default rates were only 1%, with a 20% fall in house prices. This type of extreme scenario therefore has never happened. This illustrates just how robust and resilient these types of investment grade (IG) assets actually are. Despite this low risk, we believe these types of assets are trading at very attractive yields and valuations today.

Credit quality – improving with age?

An important factor many ABS investors often do not appreciate is how the credit quality of ABS can actually improve over time. In fact, this has proven to be the case with UK RMBS where credit protection, coupon and ratings have all improved over time. To illustrate, taking the M&G Monthly Dealt IG ABS strategy as an example, since 2019, this strategy has seen 445 upgrades against only 31 downgrades over this period.

“The credit quality of ABS can actually improve over time.”
 

Over the last five years, which would have covered the COVID period as well as high inflation and interest rates over the most recent two to three years, being able to invest in an asset class where credit quality actually improves is highly desirable. Added to this, with RMBS, now that interest rates are beginning to fall, monthly repayments will reduce, and credit quality will improve further.

Can ABS offer diversification benefits?

Relative to other asset classes, European IG ABS demonstrates a low correlation. For example, an ABS may have a correlation coefficient against alternative assets.

This low correlation with other asset classes is beneficial in achieving diversification within a wider portfolio. This may lead to the added benefit of a lower annualised volatility compared to other asset classes.

“The performance of ABS lies with the underlying pool of assets.”
 

A contributory factor for this low volatility is the fact ABS tends to be far shorter term with only a three to five year life versus corporate bonds which are typically 10+ years. This is in addition to the previously described trend where the credit rating of ABS can improve over time. Together these factors serve to dampen ABS volatility.

Current ABS valuations

Does ABS offer relative value? Yes, particularly against corporate bonds. Here, yields across the ABS capital structure are far higher than those achievable in equivalent rated corporate and government bonds. Importantly, this superior yield profile does not come at the cost of higher credit risk. 

Why does this return premium exist? We believe the yield pick-up in ABS is due to the relatively harsh regulatory treatment of ABS compared to other asset classes, particularly for banks and insurance companies under Solvency 2 – the capital charges that have to be put against even very high quality, liquid ABS - which is not comparable to other fixed income products. This has led to a relative lack of demand for ABS from both banks and insurance companies. 

Future prospects for European ABS

Overall, we believe the growth in European IG ABS will continue. The drivers propelling this investment area will likely persist, not only due to the capital treatment but also the complexity premium which investors are able to secure. Further, the regulatory burden involved in investing in ABS, borne by managers such as M&G involving stress testing, reporting etc, are not going to change in the near future. We therefore believe there is potential to harvest excess return in ABS whilst taking low levels of credit risk.

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.