ABS: An untapped source of yield

Doug Charleston, Co-Head ABS at TwentyFour Asset Management, explains why more investors could benefit from the enhanced yields available in asset-backed securities (ABS).

Asset-backed securities, or ABS, remains a poorly understood and under-researched asset class among global investors, many more of whom in our view could benefit from the attractive income, diversification and flexibility it offers.

ABS transactions, also known as securitisations, issue bonds to investors backed by diverse pools of high-quality loans. The bonds are structured into layers, or “tranches”, which each carry a certain risk and return profile based on their position in the capital structure.

ABS helps banks and other lenders finance a wide range of lending activities. Consumer loans such as mortgages and car loans are frequently financed through ABS (via Residential Mortgage-Backed Securities and Auto ABS), as are corporate loans in the form of collateralised loan obligations (CLOs).

For investors, ABS can be attractive for several reasons.

First, ABS tends to offer higher yields for a given rating than more mainstream markets such as government and corporate bonds. For example, the yield on AAA CLO bonds is currently around 3.2%, compared to 3.7% for the European non-financial corporate index, where the average rating is BBB. For BBB CLOs, yields are currently around 5.5% versus around 4.9% for the BB rated European high yield bond index ¹.  As a primarily floating rate asset class, ABS also tends to be less volatile than fixed rate bonds in response to inflation and interest rates.

Second, ABS offers diversification through direct exposure to consumer credit risk and a historically low correlation to the performance of more traditional asset classes. ABS is arguably the most flexible part of the fixed income universe, with opportunities to invest across the full spectrum of ratings from triple-A to single-B, and a growing private opportunity set.

Third, ABS bondholders benefit from certain structural protections. The issuer takes on any initial losses and the subordinated junior tranches act as loss absorbers to the more senior ones. In addition, the assets naturally de-lever over time thanks to the repayment of loans in the pool. European ABS has demonstrated a very low default rate through several economic cycles, including the global financial crisis and the Covid-19 crisis, lower in fact than equivalent corporate bonds.

Despite these attractive features, ABS remains an under-used asset class among fixed income investors. This is in part due to the perceived complexity of the transactions, but this perceived complexity contributes to the yield premium ABS offers versus more mainstream markets. At TwentyFour, we have a dedicated ABS team with the expertise and the resources to analyse these deals properly and extract that premium on behalf of investors.

The total size of the public ABS market in Europe is around €597bn, with CLOs and RMBS accounting for the majority at €296bn and €138bn, respectively ².  There are also extensive opportunities in private ABS transactions, where yields can be higher since investors can use bilateral relationships with issuers to influence the structure and pricing of deals.

For those that take the time to understand and appreciate the unique features of the asset class, ABS is a compelling opportunity to target potentially strong and uncorrelated returns.