TwentyFour Asset Management
With the election of Boris Johnson as leader of the Conservative Party, and subsequently as the next UK prime minister, the chances of a ‘no-deal’ Brexit took a decisive tick upwards.
Johnson campaigned on exiting the European Union by the extended deadline of October 31 with or without a deal – “do or die” in his words – and Michael Gove, who has been placed in charge of planning for a no-deal Brexit, has said the government is now “working on the assumption” of that outcome. The new prime minister has promised a “new and better” deal with the EU, which he says will be forthcoming now the threat of no-deal has been put firmly back on the table.
Any ‘Boris Brexit’ – either a renegotiated deal or a push for no-deal – would still have to make it through a splintered UK parliament, and an early general election or second referendum still cannot be ruled out. But the risk of a no-deal Brexit has undoubtedly increased, and this is causing understandable concern among fixed income investors, both in the UK and further afield.
We believe the UK ABS market will be an effective defensive holding against the deep uncertainty around the Brexit outcome, and one which could also offer some material spread upside given the premium currently being priced into UK assets.
Brexit: three portfolio risks
When assessing a threat like a no-deal Brexit, as fixed income investors we have to consider three fundamental risks to our portfolios.
The first of these is credit risk. In simple terms, do we get our money back? What are the chances of bond coupons not being paid, or of principal not being returned?
The second is market risk. How will the event, or the threat of the event, affect the market value of our holdings? How much price volatility will there be over the life of the bond?
The third is liquidity risk. How easily will we be able to trade our positions? How will uncertainty affect bid-offer spreads? How will demand be affected?
When we evaluate these risks for UK ABS in the event of a no-deal Brexit, the results are reassuring.
Let’s deal with each risk in turn.
Credit Risk: how bad could it get?
The biggest risk to ABS investors from a no-deal Brexit, most people assume, is the potential for a recession or a sharp downturn in the UK economy, and whether this would be severe enough to prevent a meaningful number of consumers making payments on mortgages and other loans.
At TwentyFour we continually spend a huge amount of time and resources on stressing our portfolios with a range of adverse scenarios, and our results suggest that for the UK ABS market to suffer credit losses, things would have to get very bad indeed.
Ironically the most comparable period of stress could be the 1988-93 recession as the UK was forced to exit the European Exchange Rate Mechanism, when house prices dropped around 20%, unemployment jumped from 7% to 10%, and interest rates rose from 8.5% to 15%.
Mortgage repossessions peaked in 1991 at 0.77% (compared to lows in the early 1980s of 0.05%), leading to losses of less than 10bps annualised.
So we can see that the homeowner in the UK is resilient to a high degree of economic stress. This is principally because of good underwriting standards, and a strict legislative framework making it punitive for homeowners to walk away from their secured obligations. These standards have become even stricter post-crisis.
Furthermore, European ABS markets have the highest disclosure standards of any asset class anywhere in the world, and so with all the data on the underlying loans, and with transparent structures, we can model what level of repossessions and losses that would be required to break a UK RMBS deal. For example Finsbury Square 19-1 D is the BBB bond from a deal launched earlier this year, securitising near-prime residential mortgages. This bond had a 6% loss cushion provided by junior bonds and a cash reserve, as well as excess profit of 1.5% per annum that would be diverted to cover losses. So total losses over a three year period would need to be greater than 10% of the pool. Consider that in the context of that worst case historical experience of 0.1% of losses per annum.
To get 10% of losses would require more than 10% of defaults/repossessions every year, and a loss severity on each loan of 35%. Bear in mind with loss severity, that these mortgages have an average Loan to Value of 73%, so there is an additional 27% of homeowner’s equity that would take the hit before the loan suffers a loss – that is a lot of house price stress!
In short, it would take a severe and lengthy deterioration in economic conditions for a typical UK ABS transaction to begin taking credit losses. While many commentators believe a no-deal Brexit could provoke a severe downturn, the UK’s starting position were this to occur appears robust.
Unemployment is at its lowest level since 1975 and incomes are growing, though real income growth is limited. If we compare unemployment across Europe and select other core European economies in Chart 1, the UK looks favourable. We take comfort that while the economic situation may worsen, fundamentals tend to deteriorate gradually and the UK is starting from a relatively healthy spot.
The £1.3 trillion UK mortgage market has also been a consistently strong performer, even during periods of economic contraction. In the most recent recessionary period in 2009, UK mortgages experienced their worst default rate of recent times – 0.43%. Compare this to Italy, where household defaults in 2017 were still 1.3%, and the US, which had a mortgage default rate of 2.23% in 2010.¹
Market Risk: could volatility increase?
Confidence in credit risk does not necessarily eliminate the potential for short term pricing volatility, and we would expect to see some spread movement in the event of a disorderly Brexit outcome, just as we saw the turmoil across fixed income markets in the latter stages of 2018 eventually feed into ABS markets.
European ABS markets typically exhibit lower volatility than more mainstream alternatives such as high yield or investment grade corporate bonds during periods of market stress, largely due to the fact that ABS are backed by ring-fenced pools of loans, making secondary market values less beholden to swings in broader market sentiment.
Comparable periods would include the period around the referendum in 2016 for a single, specific driver, and the more generalised volatility seen throughout 2018.
In response to the referendum UK investment grade (IG) corporate bonds saw spread widening of 29bps, UK high yield (HY) corporates widened 106bps, whereas AAA and BBB UK RMBS widened 22bps and 25bps respectively – moves that were broadly replicated in BBB European non-UK ABS. Bear in mind that RMBS are typically much shorter dated than IG corporates, meaning the price impact of these spreads moves is significantly lower.
Last year UK ABS avoided most of the volatility that IG and HY suffered in the first six months, but in the second half of the year they widened between 46bps (AAA) and 62bps (BBB), whereas IG corporates widened 82bps and HY 262bps.
Another important buffer, not unique to the UK, has been the willingness of the Bank of England to use its full tool kit to maintain the strength of household finances when faced with a period of turbulence.
The BoE governor, Mark Carney, has said it is “more likely we will provide some stimulus” in the event of a no-deal Brexit. Specifically the central bank has also proved willing to maintain liquidity and funding availability in the banking sector, through programmes such as the Funding for Lending Scheme (FLS) and later the Term Funding Scheme (TFS). Given the success of these policies and familiarity markets have with them, they are now tried and tested should they be needed again.
In addition we do not think it will only be UK assets that see volatility on a hard Brexit. The UK’s relationship with the EU has been one of the drivers of volatility since 2016, but it has been bundled together with the market’s view on monetary policy, populist politics, trade war and economic data, which means that we would expect general risk tolerance to be affected by a disorderly exit.
Liquidity Risk: could trading be harder?
One of the biggest risks to liquidity in any asset class is a sudden reduction in its overall investor base, as a number of buyers decide to avoid the market altogether.
In the case of UK ABS, a capital exodus would be unlikely as the investor base contains a large component of domestic buyers, supplemented by big overseas accounts from the USA, Asia and to a limited extent Europe.
In addition, ABS is sometimes unfairly branded as a more “illiquid” asset class than regular corporate or government bonds, often simply because it is seen as an ‘exotic’ alternative to these markets.
In fact, the vast majority of senior tranches in the European ABS market are eligible collateral for central banks, and are therefore expected to be highly liquid. This has been enhanced by the introduction of new securitisation regulation and the STS best-practice designation, which has helped add liquidity by encouraging additional bank and insurance investment under Basle III and Solvency II regulation respectively.
ABS investors are also able to trade via an ongoing process of ‘Bids Wanted in Competition’ (BWIC) lists. These are essentially public auctions where a bondholder sends out a list of securities they wish to sell, inviting bids from investors. End investors can provide liquidity when investment banks are unwilling, and the BWIC process can be more economical for participating investors as banks typically charge a lower bid-offer spread than for regular intermediary trading.
One particularly useful feature of BWIC trading is that activity tends to increase during periods of volatility, such as the period covering late 2018 and early 2019. At times of market stress, when liquidity in traditional markets typically deteriorates, ABS investors can benefit from transparent liquidity.
Summary: Protection and Premium
We regard UK ABS as a key defensive holding into a period of increasingly acute Brexit uncertainty.
Boris Johnson’s government has undoubtedly heightened the risk of a disorderly outcome, one which we believe would lead to an increase in volatility in the short term at least.
However, we also think UK ABS is better protected from a no-deal Brexit than other assets markets such as investment grade corporate bonds.
Stress testing shows its resilience to even the most bearish multiples of economic downturns on record, the market is characteristically liquid and active, and it should also suffer less price volatility than mainstream fixed income alternatives in the aftermath of a no-deal Brexit.
In addition, a ‘Brexit premium’ has been built into UK ABS (and other UK bonds) over the last three years, as foreign buyers have shied away from holding sterling denominated assets due to anticipated volatility in the currency. Disorderly or not, once an exit has been completed; much of that premium is likely to diminish leading to valuation gains.
We intend to capture this premium safely and on a short-dated basis, given our belief that a no-deal Brexit is unlikely to have a direct and material impact on the ability of UK consumers to keep up loan repayments.
¹ Source: CML, UK Government