We look at the similarities and differences between covered bonds and asset-backed securities and explain the important role both asset classes can play in liquidity funds.
Key summary
- The ability to invest in both covered bonds and asset-backed securities gives liquidity funds the flexibility to respond to changing market dynamics by shifting their asset allocation between these two asset classes.
- Triple-A rated covered bonds form a large and established market with a deep investor base, making them an attractive potential source of liquidity during stressed periods.
- Triple-A rated ABS can offer top-rated credit quality and ample secondary market liquidity—along with relatively attractive yields that can boost returns.
For years, covered bonds have occupied a prominent place in liquidity funds. Bank capital and insurance solvency regulatory regimes grant these instruments low capital and solvency requirements, creating a deep investor base for the asset class and a large and liquid secondary market. But this dynamic also results in tight spreads.
Liquidity funds may be overlooking an attractive alternative: asset-backed securities
In focusing exclusively on covered bonds, liquidity funds may be overlooking an equally attractive, and similar, alternative: asset-backed securities (ABS). These bonds also offer top-rated credit quality and strong secondary market liquidity—but can also feature a yield kicker that aims to boost funds’ overall returns, which is especially welcome during periods of negative rates and tight spreads in other markets.
In this article, we explore the merits of being able to allocate flexibly between covered bonds and ABS and the role each can play in liquidity funds. We explain when market forces might compel us to favour one over the other and how we look to take advantage of the benefits each has to offer.
Let’s start with the basics: What are covered bonds and ABS?
Covered bonds and ABS are similar, but differ in important ways. Covered bonds are debt obligations issued by banks and used primarily to finance residential mortgages and public sector loans. The loans making up a cover pool traditionally stay on the issuing bank’s balance sheet, but if that bank were to go bankrupt, investors would continue to receive payment from the covered pool. Because of this extra layer of protection—sometimes referred to as dual recourse—covered bonds have a well-deserved reputation for security, typically earning them triple-A ratings from the credit rating agencies.
ABS transactions are said to be both “bankruptcy-remote” and “non-recourse”
ABS, meanwhile, are also backed by a pool of loans (or leases), but unlike covered bonds, the securities are issued by special purpose vehicles (SPV) with the underlying assets held off balance sheet. The SPV buys the underlying assets, or collateral, from a bank or other company, and funds this purchase by selling notes to investors, with the income payments dependent on the performance of the collateral.
Since the SPV is a legal entity separate from the company that originated the collateral, owns its own collateral pool, and issues its own notes, it is “bankruptcy-remote”, meaning that the SPV is designed to be largely unaffected should the originator of the assets go bankrupt. The quid-pro-quo, however, is that ABS noteholders cannot seek recourse to the originating company should the SPV experience financial difficulties. Hence, ABS transactions are said to be both “bankruptcy-remote” and “non-recourse”.
Credit quality is high
Because triple-A rated covered bonds have a reputation for safety and familiarity, they have historically traded at tight spreads. During periods of crisis, we typically see the covered bond investor base hold up better than the ABS investor base. Covered bonds can therefore add a solid low-beta allocation to portfolios.
Regulatory changes have brought greater transparency requirements to ABS
ABS notes come in multiple tranches, with the triple-A rated senior classes boasting very high credit quality, too. Regulatory changes over the past decade and a half have brought greater transparency requirements to ABS. With access to even more information on collateral quality and performance, investors can scrutinise credit risk and the cashflow generated by the underlying pool more thoroughly than ever before.
And while some covered bonds and some senior ABS notes are not triple-A rated, these tend not be of interest to rated liquidity funds, which usually restrict themselves to triple-A rated covered bonds and triple-A rated senior ABS notes. In other words, covered bonds and ABS notes held within liquidity funds typically carry the same credit rating.
In European Structured Finance, the highest one-year default rate across all classes was 2.45 per cent, recorded in 2013, according to S&P. For investment-grade classes specifically, the highest one-year default rate was 0.52 per cent, recorded in 2008, at the height of the Global Financial Crisis. In fact, the one-year default rate for investment-grade classes is reported as zero for 26 of the 36 years from 1983 to 2018.1
Diversification considerations
Covered bond legal frameworks—which vary by jurisdiction—restrict what type of loans can form part of a cover pool. For this reason, most covered bonds are backed by residential mortgages or by public sector loans.
Because only banks (and similar entities, such as building societies in the UK) are legally permitted to issue covered bonds, owning covered bonds increases bondholders’ exposure to the banking sector. Liquidity portfolios are already dominated by financials exposure and relying solely on covered bonds exacerbates this concentration.
ABS derives from a wider assortment of economic activity in a greater number of sectors
ABS, meanwhile, derives from a wider assortment of economic activity in a greater number of sectors. These instruments securitise things like credit card receivables, auto loans and leases, as well as loans and leases to small and medium enterprises, originated not only by banks but also by other types of lenders, such as consumer finance companies and automobile manufacturers. Consequently, an allocation to ABS can improve portfolio diversification and give investors access to a wider range of lenders, borrowers, and collateral.
ABS can also offer benefits from a social perspective. Funding mortgages exclusively via covered bonds may reduce mortgage accessibility for non-traditional borrowers who do not conform to traditional bank lending standards regarding salary income and credit history. The use of residential mortgage-backed securities (RMBS), the most common type of ABS, as a funding source for non-banks has the potential to make mortgages available to more borrowers without sacrificing credit quality. And small and medium enterprises (SME) cannot be funded in the covered bond markets at all as legislation does allow for it. Limiting a liquidity fund’s investments to covered bonds arguably deprives investors of an opportunity to do well by doing good.
Yield and upside
ABS involves more complexity due to its multiple tranche structure and the variety of collateral, which therefore requires deeper credit analysis. To properly evaluate the opportunities, it is necessary to have the credit research expertise to understand collateral quality and the soundness of the financial structures.
Investors can, however, expect to be rewarded for these as senior triple-A rated ABS notes typically price at a wider spread than triple-A rated covered bonds, currently around 10 to 30 basis points for RMBS and 30 to 40 basis points for auto loans ABS. This spread differential results in a better risk-adjusted return for ABS than covered bonds, in our view.
There are times when liquidity managers might still favour covered bonds
Despite the often better risk-adjusted returns for ABS, there are times when liquidity managers might still favour covered bonds, namely when covered bonds hold capital appreciation potential. For instance, early in the COVID-19 pandemic, both covered bonds and ABS experienced spread widening.
From a historical perspective, covered bond spreads widened more relative to where we normally see them trading, creating the potential for a substantial capital gain. By June 2020, as investors came to better understand the magnitude of the economic fallout of the pandemic and governments’ responses, covered bond spreads started to tighten before ABS did. When we saw that movement, we began to unwind our covered bond positions because the upside dynamic had played itself out.
Liquidity remains high
As previously discussed, covered bonds form a large and established market with a deep investor base, which far exceeds that of ABS. Liquidity—even perceived liquidity—has a price, however, and covered bond yields reflect the promise of high secondary market liquidity.
We were able to trade our ABS holdings throughout the global financial crisis
But this does not mean that ABS liquidity is lacking. In fact, our experience during the two most recent periods of market disruption does not support this view. In 2007 and 2008, secondary market liquidity for our own holdings in senior tiple-A rated ABS backed by well-diversified pools of prime collateral was not far behind that of triple-A rated covered bonds, if at all, during the global financial crisis. We were able to trade our ABS holdings throughout that period and never experienced a run on our funds.
Similarly, during the market volatility seen in the early stages of the pandemic, that secondary market liquidity for our holdings held firm.
With interest rates continuing to stay low, there are now more new entrants to the ABS market looking for a yield advantage. This is helping create additional demand for both new deals and in secondary market trading.
Which investment when?
Because markets are uncertain, the ability to switch from one asset class to the other allows investors to follow the most advantageous opportunities. We are agnostic in our preferences because both covered bonds and ABS create value, and investors should be equally comfortable with either.
Covered bonds can be a good source of triple-A rated paper and an excellent addition to a liquidity portfolio when new ABS issuance is insufficient to meet fund demand. Covered bonds can also add duration to a liquidity portfolio during periods of monetary easing.
The flexibility to allocate to both covered bonds and ABS remains as important as ever
By the same token, when new ABS issuance takes off again, investors may set their sights on locking in wider spreads. Supply has been tight throughout the pandemic, with European ABS issuance falling sharply in 2020 to €68 billion from €102 billion in 2019, according to S&P Global Ratings.2 The secondary market cannot provide enough paper to liquidity funds to make a meaningful contribution to meet investor demand. However, we expect spreads to widen throughout 2021 with additional supply.
In summary, the flexibility to allocate to both covered bonds and ABS remains as important as ever. By allowing liquidity managers to dynamically construct portfolios according to where relative value is most attractive and where the potential for spread tightening is greatest, we believe a flexible asset allocation approach is needed to deliver better returns for fund investors.
