Softer ABS rating trend calls for caution despite strong fundamentals

Historically, one of the key sources of stability in European ABS has been ratings. The market has long seen upgrades consistently outnumber downgrades, even during periods of stress, most recently during Covid-19.

This durable trend is driven by deleveraging bond structures, as loan amortisation builds protection for bondholders over time, in addition to stable fundamentals. Downgrades were so low in 2022, for example, that they barely registered. However, higher interest rates and the withdrawal of central bank stimulus since then have challenged this dynamic, with downgrades steadily building.

Over the past three years, commercial mortgage-backed securities (CMBS) have faced increasing ratings pressure (see Exhibit 1). Sponsors have struggled with diminished interest coverage, declining valuations and looming maturities, while pre-2008 mortgages and seasoned post-2008 collateral have also seen re-ratings as higher interest rates have led to rising arrears. Exhibit 1 excludes collateralised loan obligations (CLOs), which as an aside have generally seen remarkably stable ratings through the cycle, with only some recent exceptions in selective older deals where BB and B rated tranches have been downgraded.
 

Looking at the recent trend in European ABS ratings from Moody’s, the ratio of upgrades to downgrades fell from 12.4x in 2022 to 6.5x in 2025. As a comparison, for European corporates 2022 marked a low point as higher rates saw upgrades broadly equal downgrades, but the ratio has been recovering and upgrades were roughly 2x downgrades across 2025.

While for European ABS as a whole the upgrade-downgrade ratio remains healthy, there are two points we believe investors should keep in mind.

First, newer lenders without long, through-the-cycle performance data may give rise to surprises if asset performance diverges, and we expect greater tiering between deal sponsors to occur as a broader theme. This was evident in isolated form in the Netherlands in 2025, where a relatively new lender, Hiltermann, saw its auto lease ABS (Hill 2023-1) experience defaults close to 8%, well above Fitch’s base-case assumption of 5.5%, resulting in investment grade bonds being downgraded to BB.

Second, deal structures adapt over time. More recently, lower funding costs have enabled more favourable rating treatment and therefore higher leverage, making structures more prone to downgrade in our view. For example, Pepper UK’s RMBS deals have seen AAA support fall from 16.25% to 12.25% since 2023.

While reliance on ratings is not something we advocate, it is our responsibility to understand clearly what is priced into ratings and how comparable they are. This helps us to identify potential inconsistencies and factor these into our active management, both when targeting alpha relative to benchmarks and while managing risk.

ABS ratings are transparent, with methodologies that are prescriptive and formulaic. This is a positive in that, if required, we can go to considerable lengths to recreate them. This transparency was one of several safeguards established after agencies became approved by the US Securities and Exchange Commission as Nationally Recognized Statistical Rating Organizations (NRSROs) in 2010.

However, ABS ratings methodologies tend to lag reality as a result. We recall several conversations with agencies on how in small pockets of non-prime legacy UK mortgages, the recoveries on defaulting loans were low given their low average current loan-to-values (40-60%). In our view, this reflected poor property maintenance over time and the unreliability of indexed valuations as a barometer for assumptions. This is an area which accounts for several of the downgrades seen in the past couple of years.

Looking ahead in 2026, we believe fundamentals will be supportive of European ABS performance and corresponding ratings more broadly, as the majority of the market is comprised of newer collateral pools where issues are more limited.

However, European ABS investors have benefited from a “free lunch” on ratings over the quantitative easing years. Today, as economies and fundamentals are more balanced, so are our ratings. While compared to corporate bonds a strong picture remains, digging slightly deeper warrants a touch more investor caution.