Enhancing portfolios with asset-backed securities

Private markets as an asset class have demonstrated extremely impressive growth over many years. However, whilst investors may be familiar with private markets in general, this is a broad asset class comprising a diverse range of strategies, often with very different characteristics. As a result, it is easy for misconceptions to form. Within the world of structured credit, this is likely the case with asset-backed securities (ABS).       

What exactly are ABS?

In practice, ABS are very straightforward: they are securities, backed by pools of assets (collateral), typically loan or credit assets. These ABS are then sold to investors who receive both interest and principal repayment from the cashflows generated from these pools of assets. Different types of ABS transactions exist backed by a variety of different, predictable, pools of assets. These asset pools are combined and financial instruments issued against them.

Typical ABS asset pools:

Different asset pools have different risk-return characteristics allowing investors to select ABS which specifically match their risk tolerance. ABS also have different ratings – AAA through to non-investment grade – allowing investors to focus their investment on that part of the capital structure which makes most sense to them from a risk-return and time horizon perspective as well as aligned to their liquidity needs.

“ABS have different ratings – AAA through to non-investment grade.”
 

Another type of ABS instruments which are similar, but different, are Collateralised Loan Obligations (CLOs). Unlike consumer loans which form the collateral in other ABS securities, CLOs typically comprise senior secured (leveraged), or corporate and private equity broadly syndicated loans (BSLs). Whilst consumer ABS transactions usually tend to have a regional focus, CLOs can often be further diversified through exposure to specific industries.  

The securitisation process whereby ABS and CLOs are created is also straightforward.

Securitisation process:

These ABS are categorised into ‘tranches’ and rated by one or more ratings agency, taking into account their seniority within the transaction’s capital structure and carrying different coupons. Investors can purchase the appropriate security reflecting their risk-return preference.

Addressing the ABS myth

Perhaps one of the biggest impediments for investors considering asset-backed securities is the lingering legacy of the US subprime market, particularly during the Global Financial Crisis. At the time, parts of that market performed very poorly, tarnishing the reputation of ABS more widely. However, it is a myth that globally all ABS markets are the same. Specifically, the European ABS market can demonstrate a long and stable performance.

“It is a myth that globally all ABS markets are the same.”
 

We believe that the reasons for the relative attractiveness of the European ABS market are driven by the very conservative underwriting of the collateral and the strict enforcement regime, particularly concerning residential mortgages and other consumer borrowings across Europe. In fact, the credit resiliency of the European ABS market can be highlighted by the current situation with residential mortgages. The loan-to-values that mortgages have been underwritten at over recent years are far lower than would have been the case during the GFC. Over the last 15 years, ABS transactions have proven themselves to be extremely resilient, even during periods of severe economic stress.

How investors can use ABS

A clear trend among investors has been the move to diversify traditional fixed income allocations and enhance yield. The wider structured credit universe has been a beneficiary of this, which has included allocations towards ABS and CLOs as part of investors strategic asset allocation. Their appeal to investors lies in the breadth of value ABS/CLOs can offer:

• Yield enhancement: Purchasing senior AAA or investment grade ABS and CLOs may provide a yield uplift relative to investment grade-rated government and corporate bonds. Higher-yielding BB/B- rated junior and equity opportunities appealing to investors seeking up to potential ‘equity-like’ double-digit returns.
  
  
• Diversification: As the collateral for ABS tends to be consumer focussed, ABS has the potential to serve as a valuable diversifier within a portfolio which likely has a high exposure to corporate bonds. Historically, over the long-term, investment grade ABS has demonstrated a low correlation to either government bonds or equities.
  
  
• Floating rate: As most ABS in Europe are floating rate, this can work to lower volatility within a portfolio. Indeed, the floating rate nature of ABS has proven particularly valuable during the recent rate hiking cycle. Whilst rates are more likely to fall than rise from here, the pace and size of future rate cuts may well prove to be subdued, particularly with the persistent tight labour market in the UK and Europe.

“ABS can potentially be an option for investors.”
 

In terms of overall portfolio construction, the fact that investors can purchase ABS bonds rated from AAA down to single B, or even unrated junior equity tranches, means ABS can potentially be an option for many investors. Whether the investment objective is low, predictable returns, or targeting more equity-like returns, the appeal of ABS lie in their flexibility. Investors can select which parts of the universe they want to invest in and the parts of the capital structure they wish to focus on.

ABS: A complementary allocation

The role of ABS within portfolios is multi-faceted with the potential to provide both strong return uplift and diversification benefits. The fact that ABS are available across the ratings spectrum further enhances their appeal and relevance to a wide range of investors. Whilst ABS is clearly not a complete replacement for corporate bond exposure, in our view it can deserve a role as a complementary allocation offering both diversification and lower volatility benefits.

Our expertise in Private Markets

The views expressed in this document should not be taken as a recommendation, advice or forecast. The value and income from the fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise, and you may get back less than you originally invested. Past performance is not a guide to future performance.