European structured credit review and outlook: From strength to strength

Relative value is particularly compelling

European ABS performance has not only remained robust but the asset class has also offered extremely attractive returns across the capital stack relative to similarly-rated corporate bonds. Throughout most of 2023 this yield differential has been at decade highs, offering investors a continued opportunity to allocate to the asset class at historically attractive valuations.

Of course, credit risk is one of the most significant risks in ABS investing although European ABS and CLOs transactions still provide ample structural protection in our view, keeping default and downgrade risks manageable.

Issuance prospects remain bright

European ABS and CLO new-issuance volumes rebounded in 2023 after macro volatility suppressed primary markets throughout 2022. Publicly-distributed issuance totalled €91.5 billion, a level in keeping with post-GFC averages but representing a significant uplift on the €78.9 billion of supply in the previous year. 

An observable trend in 2023, and one we expect to remain in place this year, has been the much-anticipated return of bank issuers to the securitisation market. Given the roll-off of central bank term funding schemes, issuers are looking to diversify their funding base. This has ensured the supply of STS label product has increased significantly. From a demand perspective the lower associated capital charges have meaningfully enhanced the attractiveness of the product for capital-conscious buyers such as banks and insurance companies. 

“We believe the combination of strongly performing collateral, attractive valuations and significant income generation should continue to support an expansion of the investor base for ABS and Structured Credit asset classes more broadly during 2024.”

On the topic of bank origination, the turmoil in the global banking sector in Q1 2023 put the spotlight firmly on bank balance sheets, exposed asset-liability mismatches and reminded investors of the impact that higher rates can have on asset prices. With banks facing higher funding and capital costs, we believe this will encourage many to double-down on optimising their balance sheets more effectively from here, particularly with the Basel III Endgame now firmly in sight. 

We think this renewed focus on balance sheet optimisation and capital efficiency in the current environment is likely to give rise to a wealth of interesting opportunities in risk-sharing transactions like SRT and also in the consumer Specialty Finance space – with the definition of SRT arguably evolving from here. Ultimately, for many banks focusing on regulatory capital relief, there remains few alternatives to risk-sharing transactions, whether in the form of direct or synthetic securitisation and whole loan portfolio sales, as raising capital by selling shares and preferred equity remains prohibitively costly due to low stock valuations and high interest rates.

Credit fundamentals continue to stack up

Robust labour demand, strong wage growth, excess savings and government fiscal support packages have all helped protect household incomes over the past year, while many consumers have proven adept at adapting to the ‘new normal’. The recent slowdown in hiring has not been enough to cool pay growth thanks to the tightness of labour markets and sticky inflation, most notably in the UK. We see some signs that the worst of the cost-of-living crisis is behind consumers in Europe.

Residential mortgage payments are typically the largest financial commitment of households, and despite higher interest rates in 2023 we have not seen a wholesale increase in mortgage arrears.

One explanation for this – particularly in the UK where mortgage costs have been the focus of significant attention over the past year – is that the vast majority (~80%) of mortgage debt is held by borrowers in higher income brackets. The net impact of higher mortgage rates (ie. a rise from 2% to 7%) constitutes less than a ten-percentage point impact on disposable income for the top four income deciles (see the RHS chart below). The impact on affordability has therefore, on average, been relatively manageable and should be further supported by the significant decline in UK swap rates in H2 2023, if sustained, which has already fed through to consistently lower new mortgage borrowing rates in recent months. 

In general, European ABS collateral performance remained robust during 2023 and the asset class continues to offer many opportunities to gain exposure to relatively high credit quality asset pools. While we have seen an uptick in early stage arrears – particularly among non-prime borrowers – this has been relatively modest and has occurred from a very low base. Significantly, while early-stage arrears have risen, a wholesale transition into late-stage delinquencies has not yet materialised. 

Despite a still-challenging economic outlook and some moderate performance deterioration in certain segments, in core European jurisdictions such as UK, Netherlands, Germany and France, credit rating agencies were 8x more likely to upgrade than downgrade tranches in 2023. This is undoubtedly a reflection of the strong underwriting and robust structures within securitised transactions that consistently de-lever over time as borrowers repay.

Looking ahead

We believe the combination of strongly performing collateral, attractive valuations and significant income generation should continue to support an expansion of the investor base for ABS and Structured Credit asset classes more broadly during 2024 and beyond – particularly as investors pursue opportunities to optimise their asset allocations for attractive risk-adjusted returns and diversification potential. While robust credit underwriting and disciplined stock selection will remain key, we believe opportunities in the asset class will continue to look compelling relative to fixed income and credit alternatives. 

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.