By Neil Hohmann
Perhaps the most discussed conundrum among investors today is where to seek yield in this low interest rate environment. We believe that a diversified portfolio of high quality, liquid, non-traditional asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) offer an attractive solution. Non-traditional ABS and CMBS currently offer sizable (100 bps to 350 bps) spread concessions over similarly-rated corporates and traditional prime auto and credit card ABS.
Due to regulation following the Financial Crisis, U.S. commercial banks have withdrawn from many segments of consumer and commercial lending. Loans, as a percentage of bank assets, dropped to 55% in 2015, down from 64% in 2006, representing a drawdown of more than $1trn in potential loans. As banks have stepped away, long-established manufacturers and non-bank finance companies have diversified their funding sources into the capital markets by issuing ABS.
Non-traditional ABS are collateralized by equipment leases and small business and consumer loans with short durations often less than two years. These asset types are time-tested, unlike the relatively newer residential mortgage backed securitizations, or RMBS, that helped spark the Financial Crisis. Non-traditional ABS issuance has grown from $14 billion a year in 2008 to $110bn in 2015. It is now a $400bn segment of the fixed income market with over 30 distinct subsectors that offer attractively priced investment opportunities.
Regulatory pressure on the banks has similarly sparked an expansion of the Single-Asset, Single-Borrower (SASB) CMBS asset class, a non-traditional segment of the CMBS market. These securities are secured by a large single commercial real estate loan, typically greater than $500 million. Off of modest pre-crisis levels, total 2016 issuance is expected to be $25bn.
Investment grade ABS credit performance has been impeccable. We analyzed the performance of all investment grade U.S. ABS securities that were outstanding from 2008 to the present. Out of hundreds, only one issuer suffered impairment. The cumulative loss to investors was only 0.03% on the $800bn of ABS outstanding. Similarly, no investment-grade rated SASB CMBS tranche has ever suffered impairment. By contrast, investment grade corporate bonds experienced a cumulative loss of approximately 1.6% from 2008 to the present, and RMBS a staggering 11% cumulative loss over the period.
The strong underwriting and structural protections of ABS and CMBS help explain the strength of their credit performance. The underlying loan and lease types have been tested through multiple credit cycles. A typical issuer is a long-established industry leader, with an experienced management team and a track record of sound underwriting. Issuers and sponsors are incentivized to underwrite loans conservatively because they retain a substantial on-balance-sheet equity position beneath their debt. The senior class of notes is typically supported by credit enhancement of 20% to 50% of the underlying collateral value.
The high credit quality and short duration of ABS support stable returns. Historical ABS index returns exhibit annualized return volatility that is only about one-third that of broad credit indices. Price stability stems from other factors too: the tendency for ABS and CMBS to de-lever and improve in credit as they season, a stable set of institutional investors, and the broad diversity of products available within the non-traditional ABS universe.
In regard to liquidity, the largest academic study on the subject, by NYU professor Marti Subrahmanyam, concludes that ABS have liquidity similar to medium-term corporate notes. Like corporate bonds, ABS are traded in over-the-counter markets through a network of 25 bank dealers, with public price transparency provided through the TRACE system. Typical bid/ask spreads for non-traditional ABS and CMBS range from 15 to 30 basis points (bps). Given their lower capital charges and higher carry, dealers maintain a greater inventory of ABS than investment grade corporates, providing strong liquidity support for the sector.
Why does this opportunity persist? Demand has simply not kept pace with supply. The size of a typical asset-backed deal, between $200m and $1bn, is too small to interest many large money managers. Furthermore the barriers to entry for thoroughly underwriting a broad range of structured product types are high for smaller money managers. Success in this asset class requires specialized expertise and significant experience. Consequently, we expect the non-traditional ABS and CMBS sectors to remain an important and attractively priced investment opportunity.
Neil Hohmann is head of structured products research and strategy and a portfolio manager for BBH Investment Management
