It has been a challenging couple of weeks for obvious reasons, which by turns we have compared to the market volatility seen in late 2018 (the Fed at odds with the market about rate policy, the US-China trade war, Brexit), early 2016 (deteriorating economic data, energy/oil crisis, Deutsche Bank solvency), and 2011 (Spain/Italy default risk, US downgrade, introduction of Basel III) as well as the global financial crisis of 2008. Notably these are all periods where it felt incredibly challenging to be an investor, but which also provided some of the best investment opportunities most of us have seen.
As with most of those other events, European ABS have lagged the volatility seen elsewhere principally as market participants believed that the direct link to fundamental risk in European ABS remained weak – a belief we continue to hold for the significant majority of the market. However, as also seen during those other periods, as risk sentiment deteriorates eventually we expect to experience some correlation with other markets, which can often happen sharply. We won’t necessarily see the same kind of moves, but history suggests that some of the changes experienced can happen in more of a step-like manner, which exaggerates the aggression of the move. Typically this is a function of bank trading desks feeding prices through into pricing vendors.
What we can continue to have faith in is the absolute performance of our asset class. Unlike the US ABS market, the European version does not feature aircraft securitisations, European CLO exposure to the oil and gas industry is close to zero, there are very few hotel-backed CMBS deals and relatively low levels of retail in CMBS as well. The potential for most exposure to sectors or geographies that might present more “headline” risk would be in CLOs, where the volatility is typically greater, principally due to the underlying loan issuers often also issuing high yield bonds, thereby creating correlation. However, this is to overlook the structural strength of this sector and we have included an example later. We have also written recently on the resilience of RMBS to exaggerated, prolonged non-payment of mortgage interest.
There is no primary European ABS issuance in the pipeline that we’re aware of, so the technical driver of performance we’re seeing is purely through secondary trading, where supply (selling by investors repositioning/fund outflows) is keeping demand at bay. We think every ABS fund manager would welcome the opportunity to invest at current levels, but won’t until they are confident that the supply has abated and investors are aligned in recognising the value potential that currently exists in the market. We have included below a table showing current spreads available and the movement since the market sell-off.
Source: TwentyFour, Bloomberg
For more than a year now we have looked to gradually decrease risk in our portfolio in a variety of ways, all with the aim of reducing volatility and increasing liquidity. We have increased both cash (from 3% to 6%) and AAA rated bonds (from 25% to 38%), reduced the length of the portfolio from 3.2 years to 2.5 years, and also reduced our exposure to the typically higher beta CLO market from 25% to 18%, while increasing the AAA part of this exposure materially. We have kept our positioning consistent since the sell-off, apart from further focussing on increasing liquidity.
In particular, before the market really started moving we sold the only hotel CMBS deal we held, and for a long time now we have not had material exposure to Italy as we have judged the low yields on offer there (as a result of the ECB’s ABS purchase programme) unattractive in comparison to alternatives. There is nothing in the portfolio that we are remotely worried about in terms of default risk.
In the interim the move in spreads that we have seen has increased the portfolio’s mark-to-market yield from 2.1% to 3.1% (after the rate cut), despite our positioning becoming increasingly conservative over that period. We are confident that this could be significantly enhanced were our risk tolerance to increase.
As we have said already, we think the opportunity set as judged by yield vs. credit risk is the most attractive since the global financial crisis, however we have to try to guard against further price moves and we have to continue to offer liquidity to our investors at the correct price as best we can, and at the moment that liquidity is at a premium. This means we are likely to continue to hold elevated levels of AAA and cash. However, incrementally we expect there will be opportunities to add sub-AAA positions and extend credit duration to add yield on very robust credits.
While a period of lockdown would naturally be expected to lead to a higher level of arrears, the offsets to this are a) the credit profile of the borrowers are typically biased away from the most susceptible to a downturn (e.g. those within the gig economy), b) banks already have ongoing forbearance policies that are in line with what we are hearing from banks/politicians, c) the structural benefits of junior bonds, excess profit and cash reserves and d) the transparency of the loan pools that allow for accurate modelling of missed payments and defaults. In addition, the multiple recent announcements of government support are intended to act as an offset to further stress at a corporate and consumer level, and affordability should be further supported by likely lower rates for longer in the UK and Europe.
In such a scenario of low rates and government bond curves, yield will be driven by credit spread, which ABS has traditionally had more of than the rest of fixed income.
If the only thing we are really concerned about is liquidity, then what would we be looking at now if we didn’t have those concerns? In other words, what do we think are the best opportunities right now?
Well, we are seeing lots of AAA rated bonds that were trading at Libor+40bp a few weeks ago, at a significantly increased yield of L+150bp now, which in terms of multiple of the original spread looks to us to be remarkably cheap. Investors are not being paid for the credit risk, they are being paid for liquidity and conviction. No AAA rated European ABS/RMBS has ever defaulted and we see no reason for this to change.
We would highlight something potentially even more attractive, and one that deals with the larger credit risks that investors might think are prevalent in ABS.
AQUE 19-4 is a European CLO launched last year, and as such has a more aggressive structure than our favoured 2017 vintage, meaning that it would be expected to be able to take less stress. The manager HPS is one of our favoured ones, but let’s assume they add no value from stock selection or trading, and let’s also assume that none of the underlying loan issuers access those hundreds of billions of funding support that has been announced specifically to help them. On that basis, how much of an impact from a COVID-19 driven downturn does our modelling suggest this CLO could take at the BBB level?
To set a baseline, during the global financial crisis defaults on senior secured loans jumped from 1.5% to 10% for six months, remained at a still elevated 6% for another six months and then dropped back sharply to nearer the previous level of 2%.
However, the current default rate in the AQUE 19-4 pool is 0%, and the leveraged loan market default rate is currently 0.45%.
Thus our scenario for you is as follows:
Let’s take the sectors that will have the most direct stress from what we are seeing – Hotels, Gaming and Leisure, Retail, Transportation and Capital Equipment (currently 15% of the pool). Let’s start with a 2% default rate for six months, then to a 30% default rate for 16 months with zero recovery and then back to 2%. The impact would be immediate and severe, but if companies can survive then this would drop after the effects of the virus have passed.
Let’s look at the major economies in Europe – the UK, Germany, France, Spain, Netherlands and Italy (65% of the pool) – let’s again go from 2% to a spike in defaults of 10% for 16 months across the rest of their sectors, and then back to 3%, and this time we will assume a recovery of 40%.
Let’s assume a default rate on the rest of the pool starting again at 2%, and jumping to 6% for a year with a recovery rate of 40% before dropping back to the original level.
At this point our modelling shows the BBB and the BB bonds would have all their principal repaid.
The BBB rated bonds would have been trading at a spread of around 300bp before the COVID-19 crisis started. Now investors can buy that with a yield in GBP of over 8%, which we think is truly remarkable and a trade like that would likely be driving any ABS investor’s returns through the rest of 2020 and beyond, especially as these issuers we are stressing have essentially been underwritten by the UK and French governments recently.
While at the moment we are seeing a material reduction in buyers in the market, when everyone else wants to buy there won’t be many sellers of this type of opportunity.
 S&P European Lev Loan Index
 S&P European Lev Loan Index