Having your cake and eating it
In a year to forget for fixed income, European ABS gave investors largely what they look to the asset class for in 2022 – lower volatility and better performance than mainstream credit – with investment grade ABS portfolios mostly posting low single digit losses.
In our view the case for ABS looks even stronger in 2023, with rates and spreads combining to create a powerful income landscape, but perhaps just as importantly the defensive characteristics of the asset class likely to come to the fore in a post-QE world.
ABS in a ‘softish landing’
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.
Under our central ‘ softish landing ’ scenario for 2023, the consumer absorbs the cost-of-living crisis better than feared and we don’t see material increases in defaults. Older borrowers with more established jobs and income will be most resilient, favouring mortgage assets over unsecured consumer lending where borrowers tend to be younger and more likely to be bridging lower savings or earnings.
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 – compared to peaks of 8.4% and 10.6% in 2011 and 1993 respectively, this looks digestible even if extrapolated across Europe.
For CLOs, Europe does not face a material leveraged loan maturity wall until 2026 (just €13.7bn maturing by end-2024 according to Deutsche Bank), though we see challenges to loan performance as high yield companies navigate a weaker macro backdrop. Looking 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. 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 –Mortgages should outperform consumer lending and credit cards, core Europe should hold in better than the periphery, and more homogenous bank loan books should outperform those of more specialist lenders targeting higher yielding borrowers.
• RMBS withstands housing weakness – 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.
• CMBS – We see potential for further and material weakness in commercial real estate (CRE) valuations. This is 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. Logistics assets are a prime candidate for repricing in our view.
• 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 – We see limited call upside on the cards for CLOs given the cost of refinancing. For RMBS 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
We expect to see around €70bn of new European ABS and CLO issuance in 2023, flat on 2022 but down from recent years, mainly as a result of lower lending to be financed 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. That said, if early market positivity continues then tighter spreads may tempt issuers more quickly than expected, 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 pension 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 ABS credit spread curve to remain steep in 2023.
Positioning for 2023
In our view 2023 offers material yield opportunity for European ABS investors, with plenty of downside priced in but with less credit risk than other parts of fixed income. However, we will remain wary of tail risks and will look to 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 AAA spreads should mean-revert lower, 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.
• 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.
• 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.
In short, 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.