The title of our 2023 fixed income outlook did the talking on what we see as the most likely path for the asset class this year, a reversal of dreadful performance despite a fragile macro backdrop.
'The Rodney Blog 2023: A return to returns' also outlined how unique we thought 2022 had been in terms of its challenges for fixed income, with bond performance reflecting central bankers’ efforts to tame runaway inflation by unwinding an unprecedented era of loose monetary policy.
European ABS was not immune to negative returns and indeed faced some of its own unique challenges, but the relative picture was one of outperformance against broader credit markets, with investment grade rated ABS portfolios mostly posting low single digit losses. As such, European ABS gave investors largely what they look to this allocation for, lower volatility and enhanced performance over more mainstream fixed income.
In our view the forward-looking opportunity looks equally compelling, with rates and spreads combining to create a powerful income landscape for European ABS, but perhaps just as importantly, we expect to see the defensive characteristics of the asset class come to the fore in a post-QE world.
2022: ABS does its job
2022 saw a plethora of global events unfold, most notably unchecked inflation, Russia’s invasion of Ukraine with its associated energy and supply chain shocks, and the lingering impact of China’s zero-COVID policy. Uncertainty reigned and volatility throbbed through investors’ allocations, breaking down traditional correlations between risk and safe haven assets like equities and government bonds.
Against this backdrop European ABS initially performed well, with the floating rate format of the asset class offering material protection against rates-driven volatility (and ultimately driving the year’s outperformance of broader credit). However, the invasion of Ukraine in February saw correlations in European ABS creep up towards that of other credit products, and the run up to the summer saw spread widening take hold.
Late September then saw a material idiosyncratic risk envelop European ABS, as a disastrous ‘mini-Budget’ announcement from the newly formed UK government triggered a savage sell-off in Gilts, forcing UK pension funds running liability driven investment (LDI) strategies to sell their most liquid assets in a bid to raise cash for margin calls. As part of this move, a number of asset managers acting on behalf of such clients found themselves hasty sellers of investment grade ABS and CLOs as they looked to meet their own short term liquidity requirements (in part because other assets proved less liquid or more costly to realise). This resulted in an unprecedented scale of selling in ABS for three consecutive weeks.
Despite some commentators’ best attempts to regurgitate post-Lehman nostalgia surrounding ABS, this was not the financial crisis of 2008 and market participants were clearly not acting on fresh credit risk concerns; this was a liquidity question, and European ABS proved itself robust with widespread demand from banks, private equity and trading desks absorbing paper (validating the former credit question). Nevertheless, this resulted in ABS spreads moving wider, meaning as we enter 2023 they are starting further back than they otherwise might have been.
With data increasingly suggesting inflation has peaked and is now descending in the US (with Europe surprising in a similar direction), China’s zero-COVID policy falling away and UK political stability in check for now, major sources of uncertainty also appear to be passing their peak. The debate on terminal interest rates however is not settled, with market pricing out of step with hawkish central bank comments at December policy meetings, first by the Fed but particularly the ECB. Floating rate European ABS is intuitively relaxed about higher rates, as long as they do not come at the expense of a material policy error with downstream consequences for consumer performance.
ABS performance in a ‘softish’ landing
This brings us neatly to 2023, where, under our central ‘softish landing’ scenario, inflation continues to move lower and comes under control (albeit at a level above policy targets in the US, the Eurozone and the UK), and we see a moderate increase in unemployment as rates bite on growth. In this scenario, rates continue to increase in early 2023 and remain at terminal levels with only a small chance of a cut before the end of the year. We therefore don’t see rates-driven products rallying materially and credit spreads could remain wide for most of the year, though they might be spurred tighter later in the year as markets increasingly look forward to an anticipated recovery in 2024.
Against this backdrop, the consumer absorbs the cost-of-living crisis better than feared, making necessary cutbacks in aggregate, and falling short of material increases in defaults. We expect tiering to grow across Europe as is typically the case on several levels. By country, we expect stronger fiscal support headroom to be deployed in western Europe and more fragile southern jurisdictions to eventually underperform. By impact, older borrowers with more established jobs and income, and who are more likely to have over-saved through the COVID period, will be most resilient. This should favour homeowners, who typically fit this profile, versus unsecured consumer lending where younger average borrowers are more likely motivated to bridge lower savings or earnings in earlier years.
We draw a similar conclusion for corporates; better funded companies with a greater ability to pass on costs will outperform cohorts who can’t. For leveraged loans, Europe does not face a material loan maturity wall until 2026 (only €13.7bn maturing to the end of 2024 per Deutsche Bank data), so time is on the market’s side and the focus instead will be on the levels of CCC rated loans and interest coverage, both of which start 2023 from conservative levels.
We think 2023 will be the first year since the global financial crisis where we see a more textbook weakening in fundamental performance, this being the reality of a world without seemingly unlimited fiscal or monetary intervention, and this would feed through into European ABS pools like it would for all assets.
For ABS and RMBS, unemployment forecasts across the continent foretell a steady deterioration to levels that are well short of those experienced post-2008. The Bank of England’s latest 2022-2025 forecast, for example, sees unemployment reaching 4.9% this year, 5.9% in 2024 and 6.4% in 2025. This coming rise in unemployment, particularly when compared to peaks of 8.4% and 10.6% in 2011 and 1993 respectively, would lead to levels which we think are digestible, even if extrapolated across Europe. Labour markets and wage growth are stubbornly holding into 2023, so we have seen limited change in ABS pool performance to date and we don’t expect this to gather pace until the second half of the year.
For CLOs, we see challenges to leverage loan performance as high yield companies navigate a weaker macro backdrop. If we look back to 2009, 22% of loans rated B3 were downgraded to CCC, and 28% of CCC loans defaulted with a peak overall default rate of 8.3%. CLO documentation penalises holding excessive CCC assets, and this tends to result in lower CLO pool defaults vs. the leveraged loan index. In 2023 we think CCC rated loans could reach 10% of CLO pools, translating into a default rate of 2.5-3% with some element of loan extension, increasing again in 2024.
We think ABS deals make for strong credit allocations in this scenario as performance should remain well within tolerance, particularly as structural layers of protection (excess spread, cash reserve fund and subordination) help buffer deals for bondholders. Another key advantage is seasoning; pools comprised of older loans with longer payment track records historically perform better in downturns and have repaid more loan principal, reducing risk. These repayments are normally used to repay bonds in order of seniority, which reduces leverage and helps further build the level of protection, and their impact can be indirectly observed in upgrade-to-downgrade ratios for seasoned deals being heavily biased upwards even in recessions. Stress tests indicate that only severe and prolonged (multi-year) downturns would be expected to impact credit in a material way for most European ABS deals, something that that did not occur in the global financial crisis or the early 1990s when rates and unemployment were much higher.
What to watch in 2023
- Collateral quality – We think 2023 will see divergence appearing across multiple axes. Mortgages should outperform consumer lending and credit cards, core Europe should hold in better than the periphery and more homogenous bank loan books will outperform those of specialist lenders, particularly those which target higher yielding niches normally underserved by banks. Tail risk may lie in some European ABS portfolios with old interest-only loans, or with non-banks who targeted underserved and weaker clients, but this is not likely to cause credit issues for bonds.
- House prices weakness has limited RMBS impact – We expect house price declines to occur as higher rates and slowly weakening labour markets impact demand, but we think the magnitude will likely be 8-10%. Fitch’s standard stress assumptions for AAA and BBB rated UK RMBS are house price declines of 46.9% and 26.8%, respectively, but in a recent report the ratings agency supplemented this with a material increase in arrears and a further permanent decline in house prices of 10-12%. The result was that 59% of ratings would not change, 34% would move 1-3 notches and 7% more than 3 notches, with half of the changes coming in sub-investment grade rated bonds.
- Ratings – We expect European ABS ratings to remain stable and to continue bucking the trend across fixed income markets, where we think downgrades are likely to outweigh upgrades for some time. ABS ratings typically look through the cycle in terms of performance, and we do not see this needing to be re-evaluated based on our ‘softish landing’ scenario.
- CMBS – If the strength of European ABS credit risk is data, transparency and predictability, deals backed by commercial real estate (CRE) loans tend to offer the least of these, being more akin to corporate credit in this respect. We see potential for further and material weakness in CRE valuations, not unusual through the cycle, but capital flows in this market are uncertain and a new paradigm of higher rates makes capitalisation rates (the ratio of net operating income over asset value) look materially offside to us. A prime candidate for repricing in our view is logistics assets, the poster child of the e-commerce world, accelerated through COVID where such ‘cap rates’ ran under 4%. Refinancing risk on maturing loans and sponsor engagement are further reasons we believe investors should exercise caution in 2023 when allocating to CMBS.
- Tiering – With performance changing it is becoming more apparent which lenders, sponsors and CLO managers have been conservative with risk appetite, are resourced sufficiently and have the experience for a late-cycle environment. We think the impact here is most acutely felt in terms of liquidity and mark-to-market performance; some deals and issuance shelves can get left out in the cold, which may present a relative value opportunity at some point.
- Call optionality – RMBS and CLO deals typically have options to redeem embedded. For CLOs, as we get to the end of 2023 around 40% of deals will be out of their reinvestment periods, but we anticipate there will continue to be limited call upside on the cards given the cost of refinancing. For RMBS deals, we do see potential for a few non-bank and private equity sponsors to defer calling deals, though not indefinitely. Liquidity and pricing show a tangible amount of this risk is present, but this also leaves room for potential high conviction alpha.
A healthy technical picture
The balance of supply and demand tends to have a more prominent role for European ABS than other fixed income markets, and 2023 should present a favourable picture. We expect to see around €70bn of new issuance – flat on 2022 but down from recent years – mainly as less lending will need funding in the Eurozone. We expect to see less CLO issuance as M&A activity will remain subdued, and banks will lead the way as their funding needs shift from central bank reliance to wholesale markets. Under the BoE’s Term Funding Scheme for SMEs, £182.4bn of loans to banks remain outstanding and over time some of this needs to be replaced. One threat to this view is that if early market positivity continues, spreads may more quickly than expected move into a range where issuers respond with deals, a dynamic we are seeing in corporate markets already.
On the demand side we expect a gradual recovery of interest from asset managers, with some LDI monies flowing back and continued appetite from bank treasuries, mostly for investment grade parts of the market. It is less clear that sub-investment grade demand will return in the same proportion, since alternative options exist for more global credit investors and the hunt for yield has eased. So we expect the credit spread curve to remain steep in 2023.
The ECB is tapering reinvestments under its asset purchase programmes to allow for a net reduction of €15bn a month on average, which equates to reinvesting roughly half of redemptions. The modest ABS purchase programme stood at €22.9bn at the turn of the year (down from a peak of €31.2bn in March 2020) and with €9.9bn (43%) set to mature in 2023 alone. We therefore expect the ECB will look to reinvest around €5bn, but with a risk they let more mature off, so there is potential for a slight negative supply impact but only for AAA bonds and in continental Europe.
Only a quick comment on the regulatory side is warranted in 2023. As part of the Edinburgh Reforms announced by the UK finance minister in December, aimed at boosting the competitiveness of financial services, the UK Securitisation Regulation 2023 will form part of the bill. However, the initial proposal fails to reference changes to the treatment of securitisation for banks and insurers, a key obstacle for growth of the market. A few days after the UK announcement the EU Joint Committee released its own future intentions for the market, which while stating the growth of the market since regulation came into effect had fallen short of the €100-150bn per annum, did not suggest any changes to address capital treatment for banks and insurers. So, we see no regulatory tail or headwinds for 2023, moving swiftly on…
Positioning for 2023
Our late-cycle playbook for 2023 is based on two things, being simple and flexible. We have ample yield opportunities available and limited credit risk, but we want to avoid tails and maintain a higher level of flexibility.
- Quality will lead – We will look to move up a rating category where possible. Yield opportunities are plentiful and we feel confident that AAA spreads are beyond normal ranges and will mean-revert through the year, helped by constrained supply.
- Maintain liquidity assets – Volatility is likely to remain, so flexibility means careful maintenance of liquidity assets. This should be beneficial when engaging with primary deals in weak markets.
- Core over periphery – We prefer core Europe in the current environment given ABS pool performance is historically more stable here than in periphery assets. This includes the UK, which despite expected political and economic underperformance has a strong and well-regulated banking system where lending practices are robust and performance stable. We think it is therefore possible to detach some of the premium that surrounds other UK assets when considering ABS.
- Secured lending – We prefer secured lending (mainly in mortgages) over unsecured loan pools, as the performance should be less volatile and outcomes more predictable. Where we do take on consumer assets, we expect our focus will be on large lenders and seasoned assets, or older cohort deals which counters the uncertainty to an extent. European assets also offer recourse to the borrower, a difference when compared to the US and historically, a powerful deterrent to arrears and defaults.
- High quality convexity – Floating rate bonds rarely trade at material discounts, and it almost always pays to add quality names when they become available at low cash prices.
Yield is a friend once again
In our view 2023 offers yield opportunity for European ABS investors, with material downside priced in but with less credit risk than other parts of fixed income.
ABS investors have a great vantage point for assessing how the fundamentals of the economy unfold given the real-time loan-level data available to them, and this transparency is intuitively preferable at a time when we want confidence in credit risk and few surprises. Those investors who grasp ABS structural protection can reap a smoother glide path into the new cycle.
Floating rate European ABS will benefit from higher for longer rates, delivered mostly through higher coupon income rather than capital gains. We think spreads will remain wide, attractive, and broadly correlated with other credit products in 2023. Mark-to-market volatility will remain, something investors should be prepared for in the post-QE world. But also expect very few rating surprises or default risks emerging.
Yield is back and is our friend once again. Investors should enjoy the higher income, which still grows with every rate hike, and be glad of the greater visibility ABS gives them on economic fundamentals as central bankers look to skirt a hard landing in 2023.