Asset-Backed Securities – What are ABS and where do opportunities lie today?

Source: M&G, 31 October 2024 

The value of investments will fluctuate, which will cause prices to fall as well as rise. There is no guarantee the fund will achieve its objective, and you may not get back the original amount you invested. Where performance is mentioned, 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.

Addressing misconceptions

There is a misconception that European ABS is the same as US sub-prime, which was at the centre of the 2007/08 Global Financial Crisis (GFC). This simply isn't the case. The below chart plots rolling one-year default rates for all European ABS tranches in blue and global (which is largely US) ABS in green. During the GFC default rates peaked at 12% globally, but just above 2% in Europe. It is important to note that these figures reflect the entire capital structure, and in Europe the relatively small number of bonds that did default were typically non-investment grade, peripheral or CMBS (Commercial Property transactions). We are not aware of any AAA rated European RMBS (ABS backed by residential mortgages), or consumer loan ABS bond which has defaulted. In addition, M&G’s investment grade ABS fund range has never experienced a default.

Default rates in European ABS have historically been low

Source: S&P data December 2023. Rolling 1 yr default rate since 2001 (Global structured finance default study and rating transitions), M&G.

Focusing on RMBS specifically, US RMBS defaults have averaged at 4.7%, whilst European RMBS defaults have been a fraction of that, at 0.3%. This is largely due to the structural differences between both markets. In the US, during the GFC there was an ‘originate to distribute’ model whereby banks were originating ABS to sell them on without retaining any of the risk of the transaction. This resulted in a misalignment of interests and poor underwriting standards. 

In contrast, originators have to retain 5% of each deal under European securitisation regulations, which aligns their interests with investors and leads to better underwriting standards. Furthermore, the bankruptcy regimes in the US and Europe differ significantly. In the US, should a property owner struggle with mortgage repayments they can transfer ownership of the property to the mortgage lender without a personal recourse if the value of the property does not cover the value of the outstanding mortgage. This is not the case in Europe, where lenders do have personal recourse to property owners in this scenario. In practice this has resulted in European defaults being generally lower than those in the US and significantly lower during the GFC where Europe did not experience the same level of distress.

The opportunity today

Despite the superior performance of the ABS market in Europe relative to that of the US, spread levels are higher today in Europe. 

This dynamic is explained by the differing response to ABS regulation in the wake of the GFC by regulators in the US and Europe. Despite weaker performance in the US, as highlighted above, the market actually recovered relatively quickly in spread terms post-GFC. In contrast, in Europe the high cost of capital imposed on some investors to hold even the highest quality AAA rated ABS bonds has meant that the recovery has been much more protracted.

As a result, in our view the higher returns relative to corporate bonds that have been available in European ABS are technical in nature and not a reflection of higher credit risk. We believe they can be explained by factors including: 

1. Harsh capital treatment
   Capital charges to hold ABS for banks and insurance companies are far higher than for corporate, covered or government bonds which moderates demand for the asset class
   
   
2. Onerous regulatory burden
   ABS investors are required to fulfil extensive due diligence and stress testing requirements – these barriers to entry limit the ability of new investors to quickly enter the market
   
   
3. Complexity premium
   ABS is a specialist asset class which requires extensive and detailed knowledge, and therefore assets trade with additional spread to account for this ‘complexity premium’

While we do not see a catalyst for the above to change in the coming quarters, we see clear potential for the European ABS market size to increase strongly from its estimated ~€500 billion at present as banks can no longer fund themselves cheaply from the European Central Bank (ECB) as they did during the quantitative easing (QE) period. 

ABS market liquidity has increased significantly over recent years; M&G transacted with more than 40 counterparties during 2023 and traded more than £3 billion of UK ABS alone per annum over the last few years. The combination of these dynamics means that, in our view, there is an exploitable, medium term opportunity to earn excess returns in European ABS. 

Furthermore, European ABS has exhibited low correlation versus traditional fixed income and other asset classes (see chart below). This, in combination with lower levels of volatility, makes ABS an attractive allocation for investors to consider as part of their overall asset allocations.

Source: M&G IG ABS Strategy, ICE BofA ref. G0D0, ER00, HE00. Bloomberg ref. MXWOHEUR, JPEIDIVR. Data as at 30 September 2024

The market backdrop

The ABS market has shown consistently superior ratings migration relative to corporate bonds in Europe every year for the last decade. This dynamic is underpinned by the amortising nature of underlying residential mortgage and consumer loan collateral with loan-to-value ratios (LTVs) reducing as borrowers repay their debts. The quantum of upgrades to downgrades for ABS and corporate bonds over time are shown below (a 1.00x figure would convey and equal number of upgrades and downgrades during a period). 

Source: Bloomberg, Morgan Stanley, October 2024

Strategy – 30 September 2024, EUR

Key Fund terms

* estimated gross

* estimated gross

Conclusion

In our view, the level of credit risk taken by investors in investment grade European ABS is low when compared to either other fixed income alternatives of equivalent rating or relative to the yield compensation investors receive. We believe the stability of the asset class is demonstrated by the ratings stability and delivered performance shown above. In addition, we consider the diversification benefits available from ABS as a predominately consumer focused asset class with low correlation versus other asset classes to be appealing for investors relative to their existing corporate bond allocations.

Key risks

M&G Senior and Investment Grade ABS strategies

The value of investments will fluctuate, which will cause prices to fall as well as rise and you  may not get back the original amount you invested. There is no guarantee the objective will be achieved. Past performance is not a guide to future performance.

Market risk: The value of investments and the income from them will rise and fall. This will cause the Sub-Funds' price, as well as any income paid by the Sub-Funds, to fall as well as rise. There is no guarantee the Sub-Funds will achieve their objectives, and you may not get back the amount you originally invested.

Credit Risk: The value of the Sub-funds may fall if the issuer of a fixed income security held is unable to pay income payments or repay its debt (known as a default).

Interest Rate Risk: When interest rates rise, the value of the Sub-funds is likely to fall.

Derivatives Risk: The Sub-funds may use derivatives to gain exposure to investments and this may cause greater changes in the Sub-funds’ price and increase the risk of loss.

Counterparty Risk: Some transactions the Sub-funds make, such as placing cash on deposit, require the use of other financial institutions. If one of these institutions defaults on their obligations or becomes insolvent, the Sub-funds may incur a loss.

Asset-Backed Securities Risk: The assets backing mortgage and asset-backed securities may be repaid earlier than required, resulting in a lower return.

Please note this is not an exhaustive list, you should ensure you understand the risk profile of the products or services you plan to purchase.

Our private markets expertise