TwentyFour Asset Management
As one of Europe’s leading asset-backed securities (ABS) investors, we are often asked why we haven’t yet sought approval to expand the remit of our strategies to US securitisations.
Our answer is that currently we believe this would do little to improve returns (it might even lower them), and potentially expose clients to additional macro and credit risks.
Here are five reasons we think a focus on Europe remains the best-rewarded strategy when it comes to the global ABS market today.
1) The credit cycle
It is clear to us that the US is much further ahead in the credit cycle than Europe. Increasing levels of debt, and the ability to service that debt, have been a feature of the global expansion in recent years. This can particularly be seen on the corporate side, but shouldn’t be ignored on the consumer side as well. US corporates, and the US ABS market, are exhibiting signs of what we would call late-cycle behaviour, and there are two ways we expect this to affect the opportunity set in global ABS.
First, the fact that Europe is further behind in the credit cycle should give European ABS holders more confidence in the performance and price stability of their assets should conditions deteriorate. European firms are reporting stronger debt coverage figures than those in the US, and levels of leverage in Europe are still below their pre-crisis peak. Meanwhile, in our view, the quality of collateral in US leverage loans has been falling.
Secondly, for US ABS in particular the types of deals coming to market have changed. We have seen the growth of sectors that typically have lower credit quality or greater concentration risk, such as subprime autos and CLOs backed by commercial real estate. In addition, US regulators have also removed a requirement for CLO issuers to retain 5% of the economic interest in their transactions, which in our view was a positive feature for bondholders that European regulators still demand. All these developments in the US market are late-cycle, and in our opinion are not going to help should economic performance deteriorate.
2) Better credit performance
Europe has significantly outstripped the US when it comes to credit performance – i.e. defaults and losses at bond level. Indeed, European ABS has historically been, and is currently, one of the best performing parts of the global fixed income universe when it comes to loss rates.
Even taking what are widely perceived to be the ‘worst’ issuance years for performance (2005, 2006 and 2007), we see that well over 80% of all the European RMBS issued in those years has already redeemed, while expected and realised losses for that entire period are both well under 1%. On all of European RMBS issued since 2009, losses already incurred or expected to be incurred in future by investors have been exactly zero.1
There are a number of structural factors behind this superior credit performance. Stricter lending rules, publicly available loan-level data for transactions, and compulsory risk retention for issuers are just three of the investor-friendly advantages European ABS holds over its US counterpart.
3) Higher spreads
Currently, the highest spread available for AAA-rated paper in the US ABS market is around 60bp (that is in the five-year maturity, slightly more is possible if an investor is willing to take 10-year exposure). In European ABS, by contrast, spreads of 100bp or higher are available on a range of 3-5yr AAA-rated bonds, from European CMBS to UK non-bank RMBS. At the BBB-rated level the premium is even more stark, with European BBBs trading at anywhere between 250bp and 290bp, compared to the US market’s best effort of around 100bp for BBB-rated subprime auto ABS.
We’ve already seen that European ABS can benefit from shorter credit duration and a better macro environment for credit performance. Why would an investor want to dilute returns by adding in lower US spreads?
4) More effective due diligence
While European ABS has demonstrated excellent credit performance, it is still critical to conduct in-depth due diligence of all transactions and loan pools. ABS is well suited to this scrutiny, given the publicly available loan-level data on repayments, arrears and defaults mentioned above, and we commit a significant amount of resources to this work.
Just as important as rigorous data analysis is frequent on-site due diligence, conducted via visits to loan originators, loan servicers, CLO managers, physical properties (CMBS) and so on. This may sound simple, but physical proximity to the assets actually matters, and in our view gives us greater insight and confidence in our investments. TwentyFour has performed on-site due diligence across the UK, Italy, Finland, France, Spain, the Netherlands and many other locations. This is a vital part of the firm’s investment process, and it is much harder to carry out effectively without a local presence.
5) Conservative modelling
One nuanced but very important difference between the European and US ABS markets is the sensitivity of price and yield to the assumptions the portfolio managers are making.
The modelling of expected yield from US ABS transactions is typically very dependent on inputs such as prepayments, loss rates, defaults, house prices, and employment. Strong recent trends in this data from the US and globally is one of the big reasons why US ABS has performed rather well of late; in a positive economic environment managers typically have positive assumptions and this can lead to higher expected yields. However, as the cycle turns and levels of arrears and defaults rise, or house price falls leads to lower recoveries, then these changes would naturally be expected to flow through into manager assumptions. In US ABS, this can affect the yield and therefore the price, particularly in secondary trading, of pre-crisis subprime deals which have seen excellent price performance over the last couple of years.
In European ABS, there are very few bonds outstanding where realistic or even bear case assumptions on the same metrics actually affects yield or price. European ABS has a much bigger cushion to these drivers of performance.
This makes US ABS bondholders much more exposed to the prevailing macroeconomic environment than their European counterparts, and as we have already seen, given the age of the US credit cycle we can reasonably expect these data trends to reverse at some point.
1 Fitch Ratings ‘Structured Finance Losses - EMEA 2000-2016 Issuance’ (Jul 2017)