Fixed income opportunities in a soft landing scenario
European ABS primary activity has been rather subdued in recent months, with just over €12bn of new issuance putting Q2 2022 second only to COVID-hit Q2 2020 as the quietest Q2 in the past decade. Given the extraordinary geopolitical and economic backdrop, issuers have had to adapt to volatile market conditions and weaker investor demand.
The second quarter actually got off to a strong start in April. Following a brief hiatus in issuance due to Russia’s invasion of Ukraine, 14 RMBS and Auto ABS deals from France, Germany, Ireland, the Netherlands and the UK made up the bulk of the volume, while a cross-border CMBS and consumer deals from Italy and Spain were among others that made up a total of €7.6bn issued in the month. However, as inflation and recession fears intensified, ABS widened in line with broader fixed income, and primary activity stalled in the face of these sharply widening spreads. In fact, April would account for the majority of issuance in the quarter as May and June only produced €4.6bn combined.
That said, several issuers have placed deals despite the challenging market conditions, with some common themes emerging.
Firstly, we saw issuers and lead managers pivoting towards a more private marketing process; all but two of the deals placed since May have been sounded privately to potential investors and later announced publicly as ‘pre-placed’ when terms were agreed. In conditions like these one of the benefits of being a regular investor active across the full capital structure in ABS is that issuers tend to turn to their favoured counterparties to provide certainty of execution. This helps issuers avoid having to pull or postpone any deals that may have failed to garner sufficient demand if marketed publicly. For investors, the reduced transparency in syndication is typically offset by more favourable pricing and allocations, as well as a more direct dialogue with the issuer enabling them to exert more influence on the transaction itself.
Secondly, deal structures have been strengthened in response to widening credit spreads; higher bond margins have driven tougher rating hurdles leading to higher credit enhancement, but investor feedback has also been a major factor in driving deal structures. For example, when Paratus, a regular UK buy-to-let RMBS issuer, marketed a new deal just two weeks ago, it chose to increase the step-up and credit enhancement at the expense of equity leverage following investor interaction. Being able to communicate directly with issuers can allow investors to drive structural changes that are designed to provide more suitable protection for bondholders, and we are always happy to see issuers taking our opinions into consideration. Investor-friendly features such as higher step-ups, turbo amortisation and non-amortising reserve funds are now more frequent features in new deals.
Thirdly, some deals have been structured where the senior class is placed in a capital-utilisation friendly loan-note format which allows banks to deploy their underutilised lending books to participate in new deals at what currently look to be very attractive levels compared to other lending opportunities; in addition to those banks’ usual treasury operations.
We see these as positive developments for regular investors in European ABS and should help complement the already strong fundamentals of European ABS structures.
The primary market has now slowed for the typical summer lull, but with many regular issuers having held off printing new deals in Q2, we believe investors could see a range of attractive opportunities if market conditions allow the usual surge of primary market activity we’ve become accustomed to in September. Many of the market’s favoured names are likely to bring deals with more investor-friendly structures and offering markedly higher yields than the last time they sold bonds. Add to this that as an almost exclusively floating rate market, European ABS is widely seen as one of the purest hedges in a rising rate environment that fixed income investors can get their hands on, then we expect many will see this as an opportunity to lock in these anticipated higher returns going forward and finally benefit from the widening in credit spreads.