Unfairly cast as a pariah after the financial crisis, asset-backed securities have shown their true mettle during the COVID-19 pandemic. Investors in liquidity products should take note.
The COVID-19 pandemic has dealt a severe shock to economies worldwide. It would be natural for investors to now fear a repeat of problems experienced during previous crises; most obviously, the global financial crisis of 2007-2008.
Back then, the biggest culprits were US subprime mortgage-backed securities (MBS), bonds backed by the interest paid on mortgages and sold to investors, and a vast quantity of synthetic collateralized debt obligations that were linked to those MBS deals.
These securities hammered liquidity markets as borrowers struggled to make mortgage payments. As a result, all asset-backed securities (ABS), including those backed by non-US residential mortgages, auto loans and credit card receivables, were painted with the same brush, regardless of the underlying quality of the assets. Any remotely related securities were singled out and traded down. In the ensuing years, many institutional investors continued to view the entire ABS market with suspicion, with some even writing ABS out of their investment policy statements.
Check your facts
However, not only did high-quality ABS issues hold up remarkably well throughout the global financial crisis, they have also turned in a solid performance in the years since. This includes the past year, when these securities again showed their strength in the face of negative economic and market forces caused by COVID-19.
ABS offers both the potential for yield enhancement and increased diversification
ABS has long been a key investment in many liquidity funds because it offers both the potential for yield enhancement and increased diversification. AAA-rated one-year ABS paper has historically often boasted spreads of anywhere between 30 to 75 basis points over the base rate compared with an A-rated money market instrument of the same maturity, which might yield just 10 to 15 basis points.
Further, by allocating cash across a wider asset base, money market fund managers are able to provide diversification benefits for their shareholders. ABS doesn’t have as close a direct correlation in spread movements with other money market instruments.
For example, when ABS spreads widened in late February and early March 2020, it still took a while before other money market spreads widened. Conversely, ABS spreads tightened earlier and more significantly than money market instruments in the spring and summer of 2020. This lower level of correlation allows more flexibility in the strategic allocation of cash.
To astute observers, ABS’s performance in the past year comes as no surprise. Though the beginning of the global financial crisis was indeed linked closely to substantial credit losses and the dissipation of MBS tied to limited-recourse US subprime mortgages, this represented just a small fraction of the global ABS market. The UK residential mortgage market did not experience the same dislocation as US subprime mortgages. None of those issues were downgrade as a result of credit deterioration.
In Europe as a whole, the highest one-year default rate for ABS deals was 2.45 per cent in 2013, according to S&P Global Ratings; for those securities rated investment grade, it was just 0.52 per cent (unsurprisingly in 2008). It has been zero in 27 of the years since 1983 (when S&P records begin).
The ABS market is represented by several sectors that don’t move in lockstep
What’s more, the ABS market is well-diversified and represented by several sectors that don’t move in lockstep. In other words, ABS is about more than mortgages. An economic downturn won’t necessarily lead to financial deterioration in every sector to the same extent—even during a global recession. The unique characteristics of local economies and government responses, as well as the inherent support in ABS deal structures (including overcollateralization, liquidity reserves and subordination), act as a buffer against full-scale contagion.
Despite the misconceptions, we believe that the resilience of ABS, demonstrated through repeated tests, shows the sector is on firm ground and should be considered in investors’ liquidity programmes.
Those ready to do the analysis and understand the underlying collateral backing the securities have an opportunity to maximise returns from liquidity products. A combination of solid fundamentals, economic support, regulatory changes and greater liquidity have created an even stronger market than existed a decade ago.
First, the global ABS market is diversified across geographies and industries. The same forces that might propel some mortgages into default may not have the same effect on credit card receivables or auto loans.
The UK did not experience the full contagion of the US market’s collapse
More importantly, the characteristics of the US and UK economies during times of financial dislocation have key differences. It is important to note that the UK did not experience the full contagion of the US market’s collapse.
In fact, the UK residential mortgage market held up well during the global financial crisis. The UK’s relatively flexible labour pool limited the rise of unemployment (a key driver of mortgage defaults). While wages dropped in real terms, the government response was to move on fiscal stimulus, thereby lowering interest rates (and mortgage rates). With mortgages remaining affordable for many households during the crisis, defaults were rare. And while spreads on even AAA-rated UK prime retail MBS issues widened due to investor jitters (this was also the case for nearly every other investment market), none of these experienced downgrades. The fundamentals remained strong.
For example, spreads in prime UK residential MBS widened to between 350 and 400 basis points at the start of the global financial crisis while highly rated US banks saw their spreads push out to about 1,200 basis points. Even at the height of the crisis, investors had confidence in their ability to fully analyse the underlying assets within MBS deals to understand the true nature of their exposure, something that wasn’t possible with bank loans.
Rewards for investors
The disconnect between rhetoric and reality on the ABS market offers potential upside for investors. This manifests itself in wider spreads for ABS and MBS issues, which have yet to recover to pre-crisis levels. While we expect ABS and MBS to go through periods of spread widening during times of economic stress, AAA-rated residential MBS trades at an average of 62 basis points, compared to spreads in the low teens just prior to the global financial crisis.
Figure 1: UK RMBS GBP senior tranche spread performance
We can take advantage of these wider spreads for the benefit of our investors. During bouts of credit market weakness, MBS spreads have been cushioned by strong investor demand. In addition, MBS benefits from natural support levels. When spreads widen beyond a certain point, it compels issuers to seek out alternative sources of funding, choking off supply. Longer-term investors are attracted to the higher returns in these short-term instruments that this dynamic creates. Experienced fund managers who understand this market can time their trades to profitably capture these opportunities.
ABS in the age of COVID-19
The resilience of ABS has again been tested recently as COVID-19 dealt a significant blow to economies around the world. Governments have stepped in with varying degrees of support in order to prevent further economic decline, while central banks again moved to prop up financial markets through massive bond-purchase programmes.
Borrowers experiencing financial hardship were able to apply for a payment holiday for up to three months
In the UK, payment holidays and the associated temporary modifications in regulations helped to prevent negative triggers for the asset class. Borrowers experiencing financial hardship related to COVID-19 were able to apply for a payment holiday for up to three months, plus a three-month extension. Mortgage payments could be partially or entirely suspended, though interest still accrues.
In addition, payment holidays indirectly helped credit card receivables because they allowed consumers to continue making payments on their revolving debt. Many consumers are now in a strong financial position and have been able to resume making payments.
Meanwhile, the auto loan segment remained robust due to consumer demand for used cars, which led to an increase in used car prices and higher residual values.
In early February, just as COVID-19 news was starting to hit UK headlines, we reduced our ABS holdings when spreads were still relatively tight. Between March and May, we were able to take advantage of wider spread levels in ABS by increasing our allocations. We continued to add ABS to the portfolio throughout the summer, but became more selective in the names and maturities we included as spreads tightened.
Our current strategy is to look at short-dated maturities as we continue to believe the yield pick-up for longer maturities is small and offers little risk/reward incentive.
Furthermore, MBS liquidity has so far remained strong throughout the worst of the COVID-19 crisis. Investor fears that liquidity would seize up during periods of market stress did not materialise.
To be sure, liquidity funds experienced some outflows early on, which we would expect during periods of market stress. In those early months, it was unclear how severe the economic fallout would be and whether governments would be able to adequately step in to address the problem. However, we were freely able to trade throughout the pandemic. (Incidentally, that was also the case during the global financial crisis.) A wholesale run on funds did not happen, providing further reassurance that MBS can withstand severe periodic stresses.
Low interest rates have created more demand in secondary market trading
Even now, low interest rates have created more demand in secondary market trading. New deals, meanwhile, are routinely oversubscribed and market participants do not experience a lack of demand when they want to unwind their positions.
Well-positioned for the future
The recent period of market stress buoys our view of ABS and MBS further. The development of multiple, successful COVID-19 vaccines is a positive sign that economic recovery is in the offing, which will put consumers on firmer financial footing. In the intermediate term, government stimulus programmes will continue to support consumers, helping them avoid defaults on auto loans and credit cards, thereby keeping ABS credit quality strong. Low interest rates and low supply help to strengthen MBS.
Both ABS and MBS offer investors the potential for high risk-adjusted returns with good liquidity. A solid regulatory framework has brought greater transparency and significantly lowered leverage in the financial system, helping to suppress volatility.
Critically, ABS offers effective diversification for liquidity portfolios that would otherwise be heavily dominated by deals from financial issuers. As we saw in recent months, ABS is relatively uncorrelated with other credit markets, trading instead on technical factors such as supply and demand imbalances that help to insulate it from broader market movements.
We constantly analyse the relative value between sectors and actively trade in and out where we see value and favourable risk-adjusted returns. At this time, that is not in covered bonds or prime RMBS, but in non-bank issuance.
We are encouraged by a blossoming of new ABS issuance
Looking ahead, we are encouraged by a blossoming of new ABS issuance that allows skilled managers with a focus on the highest quality deals to extract consistent value for investors. ABS can offer an important source of liquidity returns in what is expected to remain a low-yield environment for the foreseeable future.
Given the headwinds, we believe investors should take a fresh look at how they can unlock the full rewards of ABS and MBS.
Reap the benefits: How to know if your liquidity fund is taking advantage of ABS and MBS
Not all liquidity funds are created equal—and neither are all liquidity fund managers. Some funds have the benefit of a keen understanding of asset-backed and mortgage-backed securities. Managers with extensive experience of carefully analysing the market can identify deals with the highest quality underlying collateral and skirt around problematic names. As you are choosing a liquidity fund for your portfolio, keep these attributes in mind:
- Familiarity: Look for a manager with many years of ABS and MBS experience across the economic cycle. At Aviva Investors, we have successfully navigated ABS and MBS before, during and after the global financial crisis. Our long experience helps us to focus on deals with strong fundamentals that are able to take advantage of government and economic support while avoiding those that are troubled.
- Research: Seek out managers with an experienced ABS research team who understand the complex factors driving ABS collateral. Our lineup of liquidity products benefits from the expert views of analysts who research ABS and MBS.
- Dedication: To fully reap the benefits of ABS, consider a focused portfolio. Our Sterling Liquidity Plus fund has sizable exposure in ABS, typically ranging between 40 and 60 per cent.
- Diversification: Since economic factors can have varying impacts on different parts of the economy, managers with a mix of ABS deals in their portfolios can be nimble enough to switch strategy from risk-on to risk-off in response to changing market conditions. We maintain our investments in ABS in several sectors, including credit card receivables, mortgages and auto loans, which are most likely to have different responses to economic factors.
- Quality: Favour managers that stick with the highest-rated tranches of deals to maintain the highest-quality portfolio. With ABS credit spreads continuing to remain wide on a relative basis, we believe we are well-compensated from a risk-return perspective to stay focused on the highest quality securities, as our fund rules dictate. In addition, we rarely invest in bonds with maturities of more than 3.5 years in the primary market.
- Personal relationships: A diligent team of ABS analysts who are in frequent communication with issuers and arrangers can anticipate supply and gain access to the most promising deals when they come to market.