Private assets
A reminder about Asset Backed Securities (ABS)
6 min read 14 Oct 24
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. The views expressed in this document should not be taken as a recommendation, advice or forecast.
Asset-backed securities (ABS) are credit instruments (bonds) issued to fund highly diversified and granular pools of underlying assets. European ABS are typically backed and secured by a specific pool of underlying loan or credit assets, including residential and commercial mortgages (RMBS and CMBS), auto loans, credit card receivables, student loans and personal loans. This diversity of the underlying collateral allows investors to choose the ABS bonds that align with their risk appetite and investment objectives.
CLOs are another type of ABS instrument and work in much the same way. In Europe, CLOs represent one of the largest components of the overall ABS market. However, in the case of CLOs the underlying asset pool is typically comprised of senior secured (leveraged) or broadly syndicated loans made to corporate or private equity borrowers – rather than the consumer loans that form the asset collateral in RMBS and consumer ABS transactions. RMBS and consumer ABS transactions tend to be regionally focused, ie Dutch RMBS, French Auto ABS, UK credit cards ABS issues, whereas the underlying leveraged loans backing a CLO can be pan European or global in nature and the pool can be further diversified by industry type as well as region.
The creation of European ABS or CLO involves a process known as securitisation. In this process, financial institutions (issuers) bundle a pool of these underlying assets and transfer them to a special purpose vehicle (SPV), which issues the ABS to third-party investors. It is this separation from the loan originator’s balance sheet which provides an additional layer of risk mitigation for ABS investors along with the inherent protections within the structure itself. The underlying assets are consolidated within a bankruptcy-remote SPV. A sponsor, often a bank or specialist (mortgage) lender, then creates new bonds or notes secured against the pool of assets and issues these bonds to investors.
These bonds are categorised into ‘tranches’, and are assigned credit ratings by one or more credit rating agency rating the transaction, reflecting their seniority within the transaction’s capital structure and carrying different coupons – thus providing investors with varying levels of risk and return, and credit enhancement Cashflows generated by the underlying loans repay interest and principal to ABS bond holders (as borrowers repay interest and principal on their loans) according to a waterfall mechanism which determines the payment priority to ABS or CLO bond holders. Senior ‘AAA’ tranches are typically the first in line to receive payments, followed by the tranches below and so on in the capital structure once senior bondholders’ payments are fulfilled. Losses, on the other hand, flow in the opposite direction, with the most subordinated or ‘junior’ tranches the first in line to incur losses – also referred to as ‘first-loss’ or ‘second-loss’ tranches. Typically, ABS payment structures can be sequential pay or pro-rata pay or bullet structures.
What are the market trends?
Supply trends/themes: There has been a proliferation of ABS and CLO primary supply in the opening stages of 2024 that has been well absorbed by investors looking to allocate to the asset class in size.
Pricing dynamics: Strong demand across the capital stack has driven spreads tighter since the start of the year as the market has rallied along with an improving market tone across the board. Yet, the yield differentials to similarly-rated corporate bonds remain at historically attractive levels and remains a very good entry point for investors.
Strong collateral performance and improving credit quality: Consistent ratings upgrade-to-downgrade ratios, even during stressed economic conditions.
How do institutional investors use them?
Investors are increasingly recognising the key advantages of including ABS and other Structured Credit asset classes as part of their long-term SAA plans. UK and European institutional investors have made allocations to ABS, CLOs and other Structured Credit assets as they seek to diversify their fixed-income portfolios and enhance portfolio yield. From the more liquid, most senior AAA or investment grade AA/A-rated ABS and CLOs for those looking for a yield pick-up relative to IG-rated government bonds and corporate bonds or utilising as a ‘cash plus’ strategy while benefiting from greater downside protection thanks to their defensive characteristics and significant credit enhancement, down to the higher-yielding BB/B-rated junior and equity opportunities for those investors looking for ‘equity-like’ double-digit return potential.
Whilst demand from investors has increased, many institutional investors, such as European insurance companies, remain largely under-allocated to the asset class – although this may be starting to change thanks in part to an improving regulatory landscape.
The compelling yield levels, typically offering a pick up versus an equivalently rated corporate bonds, and reliable income streams have attracted not only traditional ‘buy and hold’ investors like European pension schemes, endowments, and sovereign wealth funds to the asset class over recent years, but also increasingly For Investment Professionals only professional investors like family offices and private banks who have looked to make strategic allocations to the asset class. Beyond the evident yield and spread opportunities offered by ABS and CLOs across the capital structure, unlike fixed-rate bonds, these assets tend to have floating rate coupons which means they come with low or no duration risk.
The combination of robust transaction structures and strongly performing, defensive, asset collateral backing these instruments, still-attractive valuations and significant income generation should, in our view, continue to support demand for ABS, CLOs and other structured credit asset classes going forward, particularly given the uncertain and often-volatile macroeconomic and market environment.
Can you provide a comparison between the European and US markets? Is there a difference between European and US institutional investors’ appetite for these strategies?
In the US, securitisation plays a much bigger role for market-based funding of the real economy than it does in Europe given that the capital markets in the US are much more developed and issuance tends to be much more programmatic / homogeneous. For residential mortgage securitisations, in the US, issuance also stems from ‘Agency MBS’ from US government-sponsored enterprises (e.g. Freddie Mac, Ginnie Mae, Fannie Mae et al). Even though capital markets in the US are much more developed and have advanced over a number of years, it is a clear political priority in Europe to create a strong capital markets union (CMU), and officials have repeatedly advocated for a strong securitisation market as an essential component of building ‘a genuine CMU’ — with ABS remaining a vital funding and capital management tool to support the real economy by enabling borrowers to access the capital markets and allow banks to transfer some risk to investors, release capital and unlock capacity for additional lending. This highlights the integral role that securitisation plays in Europe and may support future growth of the ABS and CLO markets ahead.
European ABS markets are also fundamentally different to US ABS markets. The loan asset collateral backing the ABS typically benefits from stricter loan underwriting standards in Europe which had been brought in following the global financial crisis (GFC). The introduction of macroprudential regulation in several countries across Europe and in the UK, for instance, has made mortgage lending both safer and stronger as banks have applied more prudent standards of loan underwriting and risk management – including thresholds on the amount a lender can lend by setting restrictions on loan-to-value (LTV) and loan-to-income (LTI). This also helps to explain the lower historical default and loss experience of European ABS relative to US ABS paper, e.g. 4.7% annualised defaults in the US for all rated RMBS debt tranches over the last two decades, versus just 0.3% in Europe.
European securitisation markets are subject to more rigorous regulations that better align the interests of ABS issuers/originators and investors, including credit risk retention requirements and disclosure requirements. All ABS issued in the EU must comply with the 5% credit risk retention obligations ie. by forcing originators to hold (at least) 5% of ‘skin-in-the-game’ in securitisation transactions – this is no longer the case in US, therefore it is widely recognised that the EU’s regulation of securitisations is far more comprehensive.
From an institutional investor standpoint, the securitisation market had been villainised in Europe following the GFC and since the implementation of the Solvency II regulation in 2016, which effectively penalised investments in securitised assets for insurers operating under capital based regimes due to the high capital charges attributed to holding ABS. In late 2018 / early 2019, STS securitisation regulations came into effect which offered European insurers the opportunity to reintroduce ABS and securitisations into their portfolios. Incoming matching-adjustment (MA) reforms will likely further support insurers’ interest in the asset class, as flexibility around cashflow predictability – which under current rules had meant that asset classes without contractual cashflow certainty had not been regarded as MA-eligible – is incorporated into reforms.