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Why investors may wish to consider ABS




By Calvin Davies on 2nd June 2017


The Floating Rate nature of high quality European Asset Backed Securities is attracting increasing interest from investors concerned about the potential impact of any “normalisation” of interest rates and inflation as European Central Bank “tapering” draws closer.

 

 

Debt markets face a number of difficult challenges this year, with investors bracing themselves for future tapering by the European Central Bank (ECB), while inflation and interest rates are expected to rise in the US and in Europe over the longer term. 

 

However, Asset Backed Securities (ABS), which are bonds backed by collateral such as residential mortgage loans, consumer loans, loans to small- and medium-sized corporates, etc., are attracting increasing levels of interest as they offer investors something of a “safe haven” because their floating rate nature provides protection against rising interest rates and inflation.

 

In the present market environment, where the yields on many fixed income asset classes are low and in some cases even negative, investors are increasingly considering European ABS as an attractive alternative to more traditional fixed income categories. Many investors are concerned about the “normalisation” of interest rates and inflation in the medium term and, in order to mitigate the impact of this, they are seeking exposure to good quality investments with a floating interest rate, such as European ABS.

 

Despite the consistently strong fundamental performance of ABS in Europe, the asset class is still either unloved or unknown by certain segments of the investor universe. This is one of the reasons why it still offers a yield pick-up compared to more traditional fixed income asset classes with a similar risk profile.

 

The yield pick-up, together with the floating rate coupon, is proving to be an attractive combination in the current market environment. ABS spreads have been moving tighter, but the asset class still offers attractive relative value versus similarly rated investments in other fixed income asset classes such as Sovereign Bonds, Corporate Bonds or Covered Bonds. The graphs below show generic yield comparisons in order to illustrate the difference in yield between ABS and other comparable asset classes.

 

 

Although issuance levels have not as yet regained the levels seen before the Credit Crisis, the European ABS market has seen a number of positive developments in recent years as the industry has moved toward greater transparency and standardisation:

 

·         Regulatory initiatives supporting improved market practice, notably:

-          Improved alignment of interest through risk retention (“skin in the game”) by the originating mortgage bank or finance provider.

-          Provision of loan level data on the underlying collateral via the European DataWarehouse.

·         Prime Collateralised Securities (PCS) introduced in 2013 to provide quality kite-marks for transactions - focus on transparency, quality of collateral & reporting.

·         Tighter criteria at the rating agencies, resulting in more robust structures.

·         Eurosystem (the combination of the ECB and the various National Central Banks across the Eurozone) endorsement of, and support for, the asset class via their ABS Purchasing Programme.

 

Also, there are initiatives by European regulators that are positive toward the asset class:

 

·         Efforts to revise/harmonise the current EU regulatory framework for securitisation form a key part of the European Commission’s Capital Markets Union initiative.

·         The European Commission is seeking to deliver as much as EUR150bln of new lending and to diversify funding sources for borrowers traditionally reliant on the banking sector.

 

Nonetheless, investing in the ABS market requires specialist expertise and experience. ABS is a credit product, and investors are therefore subject to credit risk, as well as potential market/price volatility. Historical credit losses generated by European ABS have been very limited, and credit performance has been positive.

 

Despite this, it is important to have a thorough understanding of the underlying pool of collateral, the business model of the originating mortgage bank/finance provider, and the structure of an individual transaction. Moreover, it is crucial to understand the dynamics involved in this particular part of the fixed income market.

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