10 min read 10 Feb 22
European ABS were in high demand in 2021, as investors sought embedded protection against anticipated interest rate rises. In a higher inflation environment, expectations of monetary policy normalisation have driven increased volatility in the wider fixed income universe. The broadening appeal of ABS and investors with plenty of cash to put to work led spreads to tighten across the capital structure, with significant compression between senior and mezzanine tranches.
In terms of underlying fundamentals, the picture was and remains generally positive for consumer credit. Delinquencies in underlying loan pools remain low by historical standards, even as policy makers withdraw their support schemes.
What’s more, robust underwriting criteria, particularly in the form of stress-testing against interest rate rises, should help to ensure that delinquencies in consumer credit do not significantly impact ABS structures, especially in investment grade tranches, where high levels of credit enhancement are designed to insulate investors from potential principal losses.
In collateralised loan obligation (CLOs), the story of 2021 was one of improving metrics across credit, market value and structural portfolio tests. Weighted-average rating factor (WARF) scores have declined by around 150 points and CCC buckets by around 1.5%. The outlook for leverage loan defaults also continues to improve, with rating agency estimates for 2022 being revised downwards. Fitch’s estimate of 2.5% in its base case scenario is down from 4.0% previously on the back of robust credit market conditions and a successful vaccine roll-out1.
This strong performance across different areas of European ABS ultimately saw the asset class outperform many areas of fixed income, bucking the negative performance trend seen in government and corporate bonds.
The European ABS market had a bumper year in terms of primary market supply in 2021, with €115bn of issuance. Positive net supply in the region ensured the investment universe returned to growth, with an overall outstanding size of over €550bn – an increase of around 8% on the previous year2.
The key drivers included record CLO issuance in both primary and refinancing/reset markets, which was propelled by spread tightening on CLO liabilities and increased merger and acquisition (M&A) activity supporting strong issuance on the loan side.
Elsewhere, we observed continued growth in residential mortgage-backed security (RMBS) issuance from specialist lenders in the UK. The absence of traditional high-street banks from the securitisation market has added momentum to the spread tightening in the UK buy-to-let (BTL) and non-conforming RMBS markets.
A resurgence in the European commercial mortgage-backed securities (CMBS) market this year was also a welcome surprise. The highest number of transactions and deal volume since the global financial crisis (GFC) ensured there was a broad spectrum of deals and collateral for investors to consider. While logistics remained a key sector, the market also embraced new asset classes, such as research and development facilities.
The outlook for issuance in 2022 is broadly positive, with market forecasts generally in the region of €100bn. The largest sectors continue to be CLOs at €36bn, RMBS at €31bn and auto ABS at €20bn.
ESG ABS have been an area of increasing focus for M&G in recent years, as we noted in our recent article on the subject. We were pleased to see ESG-specific non-CLO securitisations total €4.6bn issuance across eight deals in 2021, marking a significant increase from c.€0.5bn p.a. in the previous five years. Notably, the market has moved away from its sole focus on green mortgages to also include social bond transactions and broader range of collateral types, including social housing CMBS and consumer loans.
In CLOs, 23 transactions with ESG criteria were priced from a total of 14 different managers and we believe this will be a strong source of growth in the coming 12 months. The market has shown a clear appetite for these types of transactions and we would therefore expect to see further developments and growth in this area in 2022.
Meanwhile, simple, transparent and standardised (STS) securitisations, which are of particular importance to insurers operating under Solvency II regulations, also experienced significantly higher volumes.
In 2021, around 48% of eligible issuance volume was classified as STS-compliant, which was moderately below expectations; however, supply is forecast to rise to around 55% of total issuance in 20223, as central banks start withdrawing cheap funding for borrowers. We have also been encouraged by the increasing diversity of STS transactions, spanning RMBS and auto loans to CMBS and consumer ABS, among others.
The past year has proven tough for investors in traditional fixed income sectors, where interest rate volatility has ensured one of the worst years in recent history for investment performance. We believe this is likely to continue in 2022, as bond markets react to the forward guidance issued by central banks, while expectations for the speed of monetary policy normalisation fluctuate.
European ABS has been an exception to this performance trend. A combination of relatively high carry and the floating rate nature of the asset class continue to be a potentially attractive proposition. While future Covid-19 variants and the rising cost of living present potential challenges, we remain optimistic about underlying asset performance, as wider recognition of the floating rate nature of the European ABS market should prove a supportive tailwind over the coming year.
1 Source: Deutsche Bank Research, European Securitisation Outlook 2022, p27-28, 15 Dec 2021
2 Source: Deutsche Bank Research, European Securitisation Outlook 2022, p4, 15 Dec 2021
3 JP Morgan, International ABS 2022 Outlook, p9, 23 November 2021
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.