Securitisation and asset-backed securities (ABS) are words that strike fear into the hearts of some investors, with their connotations of the credit crunch. This misplaced fear and avoidance of ABS by large parts of the investor market has led to significant opportunities for those willing to spend the time to understand the asset class.
In their simplest form, asset-backed securities are bonds backed by specific pools of financial assets – such as residential and commercial mortgages or corporate loans – where the coupons and principal payable to the bondholders derive directly from the underlying assets.
Although the relevant underlying assets will generally have been originated by a bank or financial institution, the deals are typically structured so that the bonds are issued and the underlying pool of assets are held by a legal entity that is independent and segregated from that bank or financial institution.
The pool of assets is thereby protected from outside events, such as bank bail-in regulations, that could affect the originating bank or financial institution.
The sector has been tarnished by the US experience. Although European ABS share the same acronym, there are some very important differences which have led to strong fundamental stability and performance that is not reflective of the yields available so there are key differences between the two markets.
The acronym RMBS (residential mortgage-backed securities) was also shared across markets, despite fundamental differences between mortgages in different countries, the business models of lenders across those geographies and the structures used.
These differences have led to a significant divergence in performance and have often meant that the significant underperformance exhibited by US RMBS, for example, has tainted European RMBS simply due to the shared acronym.
Prime performance
In a recent study of European deals, Fitch estimated a lifetime loss-rate of only 0.2%. When compared to other fixed income sectors, not only sub-prime RMBS from the US but also European high yield or even European sovereigns, this would be the strongest performance seen.
When considered in detail, the differences between Europe and the US explain the substantial performance differences to date.
Prime mortgages in the US are ultimately financed by government-sponsored entities such as Fannie Mae, so the US RMBS market is a ‘non-prime’ market. By comparison, of the €454bn RMBS market in the UK just €30bn is classified as ‘non-conforming’ and the quality of these mortgages is significantly higher than that of US sub-prime.
Jurisdiction also plays an important part in judging the quality of an RMBS transaction, as differences in consumer credit laws vary widely.
A borrower in the UK mortgage market can expect to have their house repossessed should they continuously miss payments and default on the loan; what’s more, the lender can pursue the outstanding claim through the courts and recover any losses for a further 12 years.
By contrast, a borrower in the US who defaults is not pursued once the property has been sold. This has significant implications for all borrowers once their property is worth less than the outstanding balance on the mortgage, and provides no incentive for a borrower to continue to service their mortgage debt when there is a collapse in house prices.
The final key difference between the US and the European markets involves the reason for doing it in the first place. In the UK the main reason for the creation of the RMBS market was an attempt to source cheaper levels of financing. In doing so, the sponsoring bank retains the ‘first loss piece’ – that is, they lose money on a deteriorating transaction before the RMBS investors do.
In the US market the standard approach was to pass all the risk onto investors, with the originator of the mortgages retaining no exposure to their performance. This ‘originate-to-distribute’ model does not align the interests of the borrowers, the lenders and the RMBS investors, in stark contrast to the European model.
Deep and liquid
The European ABS market covers nearly €2trn of securities, with RMBS accounting for over 60% of that market. Around 80% of ABS is investment-grade, and this part of the market is deep and liquid, particularly the larger tranches of prime UK RMBS.
European ABS have long been used in the interbank markets, and have been one of the collateral items of choice for central bank repo operations with banks.
Liquid cash already gives a very low return, with increasing risks from bank bail-in legislation, as the case of Cyprus demonstrates.
The top AAA tranches of UK prime RMBS offer both security and above-cash income, with the opportunity for some additional capital appreciation. ABS bonds are issued by purpose-built vehicles that immunise the investor from the performance of the sponsoring bank by ringfencing the collateral pool from the sponsor.
Long after the demise
For example, the Granite RMBS transactions have continued unaffected long after the demise of the originating bank, Northern Rock. More recently SNS Bank in Holland was another example of bail-in where bank debt holders suffered losses but the RMBS bonds were unaffected.
Starting with some top-down analysis, a quick look at the BAML Sterling Corporate & Collateralized Index (the benchmark investment-grade corporate bond index) gives the current yield as just 3.49%, and even to get that you have to be exposed to a portfolio of bonds with an average maturity of over 13 years, with a weighted average rating of single A. Financials make up 40% of the BAML index, and provide most of the yield.
It is fair to say that further positive performance in investment-grade corporate bonds will be driven only by gilt yields dropping and further spread compression, mainly in financials. This is why we do not favour the investment-grade corporate bond sector, and think investors can gain at least the same upside elsewhere, without having to take the gilt risk.
Even where investors do believe in financial spread compression, there are far better opportunities to be had. An investment-grade RMBS and ABS portfolio is floating rate, containing no sensitivity to gilt yields. A portfolio of similarly rated ABS with shorter credit duration will still yield investors close to 4%. We think that is well worth considering in the current climate, as these securities are likely to be among the safest anywhere in the fixed income universe and the yield actually benefits from rate rises.
Fixed income in a fix
Overall, attractive levels of income have become difficult to generate from many investment sectors, including fixed income, due to a number of factors and this scenario is unlikely to change materially for a number of years.
As the scenario has caused investors to investigate specialist sources of income, asset-backed securities offer the potential for attractive risk-adjusted returns. European ABS in particular offer open-minded investors an attractive income source that will benefit from future interest rate rises, unlike large parts of fixed income. An opportunity exists to buy these assets at attractive yields with a high degree of predictability around performance.
