European ABS: A compelling tool for DC default strategies

Asset-backed securities (ABS) are credit instruments – i.e. bonds – secured against a collective pool of underlying assets. Investors who are unfamiliar with ABS often have pre-conceptions about the asset class and approach with caution. Many will still have vivid memories of the Global Financial Crisis (GFC), during which US sub-prime assets were at the centre of the turmoil. However, there are key structural differences between US and European ABS, which have led to a markedly different experience for investors in those markets. 

“Despite misconceptions, ABS have proven to be incredibly resilient during periods of market turbulence.”
 

Despite the UK’s defined benefit pension schemes taking advantage of the opportunity in European ABS over the last decade, the asset class is underrepresented in DC pension portfolios today. ABS strategies vary widely and cater to different preferences and risk appetites, however we believe several core characteristics make the asset class attractive for inclusion as part of a diversified fixed income allocation.

Key reasons for DC schemes to consider ABS: 

• ABS typically offer a return premium over equivalent rated corporate bonds, supporting the growth of savings over time. 
• Their floating rate structure can help protect savings in inflationary environments. 
• DC schemes could create more resilient default fund structures by diversifying fixed income risk with ABS.
• It is a defensive asset class that can protect members’ savings during volatile periods in markets.

Understanding the securitisation process

Securitisation involves pooling similar types of loans, such as mortgages or consumer and small business loans, which produce regular interest payments. These assets are pooled inside a bankruptcy-remote special purpose vehicle (SPV). This collateral provides security backing a variety of ABS bonds, which are sold to investors. 

These bonds are split into ‘tranches’ that represent their seniority in the transaction’s capital structure, usually categorised as senior, mezzanine, junior and residual (equity) tranches.

Cashflows from the collective asset pool are distributed via a ‘waterfall’ structure. This means that bonds in senior/AAA tranches receive principal and interest payments first. Once these payments to senior bondholders are fulfilled, investors in the tranche below receive their payments. Meanwhile, losses flow upwards, which means the most junior tranches incur losses first. Senior tranches only incur losses once all junior tranches have defaulted. 

Senior (AAA) ABS represent the largest, most liquid part of the market and they normally offer a significant yield premium above cash-like assets. This may suit schemes seeking to reallocate cash that is intended to be held in a default fund for at least 6-12 months. Investment grade (AA, A and BBB) securities comprise ‘mezzanine’ tranches that sit between senior and junior debt. These are better suited for investors with a medium-term horizon of at least 2-3 years. Investment grade ABS strategies typically command higher yields relative to IG corporate bonds. 

A tale of two markets: US vs European ABS

There is a misconception that European ABS are the same as US sub-prime, which were at the centre of the 2007/08 Global Financial Crisis (GFC). This simply isn't the case, there are key structural differences between the two markets.

During the GFC, the US operated an ‘originate to distribute’ model, whereby banks were originating mortgage loans in order to sell them to third party investors; therefore, not retaining an economic interest in the loans’ fundamental performance. This lack of alignment of interest between banks and investors helped accelerate the proliferation of poor underwriting standards in North American mortgages, in our view.

European securitisation regulations require originators to retain 5% of the capital structure of ABS transactions they issue, which we believe better aligns their interests with those of investors (‘skin in the game’). 

Cultural and legal factors

The bankruptcy regimes in the US and Europe exhibit stark contrasts, particularly in the treatment of mortgage defaults. In the US, homeowners facing difficulty with mortgage payments can often return the keys to the lender, without personal recourse, even if the property value falls short of the outstanding mortgage.

“European ABS offer a pickup in yield versus equivalently rated corporate bonds across rating bands, meaning there is potential for investors in the asset class to earn a return premium and help grow DC savings.”
 

Conversely in Europe, lenders have full recourse to a borrower’s other assets. This can have far reaching consequences beyond the loss of the property. European borrowers therefore typically prioritise mortgage payments above other financial obligations, promoting a more stable and predictable market. 

European ABS defaults have typically been lower than in the US. During the GFC default rates peaked at 12% globally, but in Europe were significantly lower, at 2%¹.

Focusing on RMBS specifically (ABS backed by residential mortgages), since 2001, US RMBS defaults have averaged at 4.7%, whilst European RMBS defaults have been a fraction of that at 0.3%.

How ABS could help grow DC savings

European ABS offer a pickup in yield versus equivalently rated corporate bonds across rating bands, meaning there is potential for investors in the asset class to earn a return premium and help grow DC savings. The higher returns potentially available in European ABS are due to structural factors and not a reflection of higher credit risk. 

ABS have delivered a persistent return premium over equivalently rated corporate bonds over time. The differential is primarily explained by: 

1. Complexity premium
   ABS are a specialist asset class which requires extensive and detailed knowledge. Assets therefore trade with additional spread to account for this ‘complexity premium’. 
   
   
2. Behavioural biases and misconceptions
   Investors’ anchoring to negative experiences in the US sub-prime market has created a persistent valuation anomaly in European ABS markets, which have demonstrated high levels of structural resilience, large liquid trading volumes and a return premium over equivalently rated corporate risk.
   
   
3. Harsh capital treatment for certain investor types
   Capital charges to hold ABS for banks and insurance companies are far higher than for other corporate, covered or government bonds, which moderates demand for the asset class. Pension funds and other investor types operate under different regulatory frameworks, which do not impose the same stringent capital requirements for ABS holdings. 
   
   
4. Regulatory hurdles in ABS investment
   ABS fund managers are required to fulfil extensive due diligence and stress testing requirements. These regulatory hurdles create barriers to entry, limiting the ability of new investors to penetrate the market. 

Yield on M&G ABS vs. corporate bond index  

There is an exploitable, medium-term opportunity to earn excess returns in ABS, in our view. The following demonstrates this relative value on offer for investment grade ABS, using the estimated yield on M&G ABS Funds versus equivalently rated corporate bond indices for illustrative purposes. 

These figures are gross and based on the Aladdin fund yields of the equivalently rated strategies. These take into account the assumptions and cashflows produced by the ABS credit research team for the underlying assets in the fund.

Protective by nature

A key feature of ABS is its floating rate structure, which when compared to traditional investment grade fixed income assets can dampen some of the volatility associated with changes in interest rate expectations.

ABS securities issued in Europe are typically floating rate instruments. Their coupons adjust periodically and are linked to short term interest rates, resulting in near-zero interest rate risk. Unlike traditional fixed income instruments, which are susceptible to changing interest rate and inflation expectations, the impact of interest rate moves on the capital value of ABS assets tends to be lower, which can offer protection during periods of uncertainty. 

Building resilient default funds with ABS

Despite misconceptions, ABS have proven to be incredibly resilient during periods of market turbulence. To illustrate the defensive quality of European ABS, we include some analysis below which demonstrates the asset class’s stress resiliency using an AA rated RMBS deal as a typical example of the economic turmoil these structures can withstand.

Diversifying corporate exposures

DC schemes can access new sources of returns in residential and consumer assets. The primary issuers of ABS are financial institutions, notably banks, which use securitisation as a funding and de-risking tool. When these institutions lend to consumers and businesses, they may lend large amounts with varying payback periods. By pooling the loans and selling them to investors these institutions can obtain new capital to continue lending.

European ABS offer a valuable opportunity to diversify away from corporate exposure with collateral backed by consumer assets such as mortgages, auto loans and credit cards. Issuance across sectors is expected to continue to grow as banks can no longer fund themselves as cheaply via central banks schemes, as was possible during the QE period – there has been around £60.1 billion of new issuance in the first half of 2024 alone².

A strategically diversified fixed income portfolio can improve resilience during periods of market turbulence. Our analysis of M&G’s own investment grade ABS strategy highlights the low correlation its returns have had to global equities and corporate debt indices, which have traditionally been held as cornerstone investments in DC default funds.

A key contribution to DC default strategies?

Although there are various risks entailed when investing in ABS – including a deterioration in the performance of the underlying collateral - investors can seek to mitigate these 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.

“European ABS offer a valuable opportunity to diversify away from corporate exposure with collateral backed by consumer assets such as mortgages, auto loans and credit cards.”
 

With this in mind, we believe asset-backed securities present a compelling opportunity for DC schemes to improve the structure of default funds. For schemes willing to navigate the perceived complexity of the assets class, ABS can be used as a tool to grow savings and reduce risk, by taking advantage of the asset class’s protective qualities. ABS have demonstrated defensiveness during turbulent periods and have continued to offer high trading volumes, which can support DC schemes ongoing liquidity needs as members approach retirement (and beyond). 

The spectrum of ABS spans from AAA through to mezzanine and subordinate tranches, which can perform distinct roles in a default fund. We view senior asset-backed securities (AAA) as an accessible first step into ABS for those investors seeking a yield-enhancing alternative to long-term cash holdings (given the high liquidity) in the latter stages of an accumulation phase journey (or through into retirement solutions). Alternatively, investment grade securities (AA/A) can complement existing holdings, by delivering a yield premium and improving diversification in a portfolio of fixed income assets. 

¹ Across the entire capital structure.
² J.P. Morgan International Securitisation Research, August 2024.
 

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.