Complexity barriers
Aside from the reputational issues one of the main barriers to ABS is its complexity and an underlying misunderstanding of its value.
Under the current ABS structure, access to the pool of assets against which investments are secured is divided into tranches of bonds, or notes, of varying seniority – typically senior, mezzanine and junior tranches. Cashflows from the underlying pool of assets are distributed to investors with the lower-risk, lower-interest securities (usually senior tranches) receiving payments before the higher-risk junior tranches.
“People intuitively get the asset-backed part but struggle with the concept of putting all these obligations together in one financial instrument, so some people are not able to take it any further,” says Guirguis.
Blackrock director of securitised assets Christian Holder adds if you look back to a typical transaction originated in 2005/06/07 you will see multiple points in terms of attachment risk, including class A (typically AAA)-rated securities down the spectrum to classes B, C and D, which would have been lower rated at launch.
“Complexity has put people off – that is a fair charge against the asset class,” says Holder. “There can be triggers which turn on or off cashflows to different asset classes. There are many moving parts which can make it difficult to pinpoint a cashflow and price a bond precisely. Deals issued post-crisis are simpler to understand and model.”
This uncertainty of cash flow might put off investors more attuned to the regularity and certainty that comes with a traditional bond, particularly as many investors do not have the in-house expertise to adequately analyse ABS. Therefore, as with other asset classes, it is extremely important for investors to do their homework and pick the right manager.
“Picking the right fund manager is probably the most important thing a pension fund can do – a manager with a long track record that goes back to the bad old days of 2007/08,” says Guirguis. “If you are able to pick a manager that has succeeded in those periods the asset class from a fundamental and technical perspective is extremely strong.”
Investors might also be put off by a perceived lack of liquidity around the asset class but according to TwentyFour Asset Management partner and fixed income portfolio manager Ben Hayward, as gilt yields have been crushed by quantitative easing, bonds have benefitted from a compression of yields as a wall of cash has been pumped into the system through liquidity action.
Hayward says: “Until last year the big injections of liquidity from the central banks had not fed through to the ABS market. In July of last year the Funding for Lending Scheme was announced by the Bank of England which funded mortgage lending for banks more cheaply than the RMBS market would, drying up RMBS supply, and with the ECB cutting the deposit rate, and yields on other low risk asset classes being suppressed by QE, more buyers came into the market chasing fewer assets.”
Better security
The credit structure of ABS protects investors these days because after the bank or originator combines together the pool of assets it sells them to a special purpose vehicle (SPV) whose function is to hold the loans/ mortgages as assets and issue the ABS bonds. If the bank gets into trouble it has no recourse to the assets so the investor is protected from the default risk of the bank and country of issuance.
Furthermore, regulatory development now requires the bank to keep a minimum percentage of the assets on its balance sheet to align its interest with investors. Elsewhere, US agency mortgages – those issued by the likes of Fannie Mae and Freddie Mac – now have standardised underwriting rules and sub-prime MBS have actually performed very well over the past 12 months as appreciating US house prices have made the underlying collateral of mortgages increase in value and stabilised prices.
Russell’s Smears says the ABX.HE AAA 2007 series – an asset-backed securities index of AAA securities (at origination) of subprime loans issued in 2007 – is actually up around 48%, at the time of writing.
“Sub-prime mortgage-backed securities have delivered something like 48% because they were so beaten down after 2008 that they became incredibly liquid and people were marketing them down to zero,” he says.
Looking at the wider performance, data from M&G Investments over 12 months to 13 December 2012, shows an investor who invested in ABS at the start of last year would have received a total return of 10%, compared with 7.2% and 2.7% from investment grade and government bonds, respectively (see Figure 1).
M&G head of institutional distribution Bernard Abrahamsen says: “Most institutional investors recognise this market can offer more stable AAA-rated risk than Europe’s sovereign bond market and that many can deliver returns ahead of similar rated non-financial corporate bonds.”
Investors are using ABS in several ways in their portfolios. Some are opting to use it as a short-term cash equivalent investment with the likes of senior credit card and residential mortgages offering Libor+40/50 basis points (bps), while others are using it as part of their core credit allocation where they might be allocating to senior CMBS. Elsewhere, it is being used as part of a punchy high yield product.
Guirguis says Insight Investment has seen investors move out of cash equivalent-type investments into ABS because it yields more for no real addition to risk premium. This, he says, has been attractive for a number of investors in the rates market be it gilts, bunds or Treasuries.
“A diversified portfolio of AA/AAA-rated ABS assets is probably yielding Libor+200bps. If you accept the premiums on offer, a fairer long-term spread is around Libor+50bps. We think senior ABS market remains, at a multiple of four, cheap to where we think long-term fair value is,” he adds.
In the mezzanine part of the market investors are looking for returns in the five to lowteen percentage window, says Guirguis. But he says this part of the market is witnessing a huge supply/demand imbalance – demand for mezzanine is strong but there is currently not the supply of new issues and will not be until spreads tighten.
“You may make greater risk-adjusted returns at the mezzanine part of the capital structure,” he says. “But for clients looking for a rates or cash-equivalent product the ABS offering at the senior level makes a more compelling proposition,” says Guirguis.
Another draw of ABS is it tends to use floating rate notes and in the current low interest rate environment it is assumed rates will inevitably go up at some point in the future.
“If you buy an ABS floating rate note the yields are currently not very high but at least if interest rates go up in the future you will profit,” says Swiss & Global Asset Management Julius Baer ABS Fund co-manager Matthias Wildhaber.
Keeping on the straight and narrow
So ABS might be back in the frame for institutional investors, but could the asset class suffer the same fate again? Of course there is always a risk but it seems a great deal of the leverage in the system then has now unwound and investors are far less levered, especially with regulation such as Basel III coming into play.
Holder says: “Ratings agencies won’t be rating to the standard they were and people won’t be buying to that standard anymore, and the whole leveraged-money, maturity contraction trade has gone.”
Hayward meanwhile explains prior to the credit crunch ABS was an investment that typically featured as a part of a levered portfolio, the funding of which dried up in 2008 and holders were forced to sell the assets to redeem the funding. These assets had to reprice to offer a suitable yield to the new buyer base, leading to falls in the market. This, he says, has little to do with the fundamental performance of the bonds or their collateral.
“To get back into that [pre-crisis] position would require massive amounts of leverage to be pumped back into the marketplace and we are not seeing that at the moment, nor are we likely to,” says Hayward.
“We will see mark-to-market volatility looking ahead but that is likely to be reflecting a wider market risk aversion rather than a fundamental issue with the bonds’ ability to pay their coupons and principal going forward.”
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