Asset-backed securities (ABS) are a type of bond, typically issued by banks or other lenders.

What makes ABS different to conventional bonds, such as government or corporate bonds, is that they are ‘secured’ against a diversified pool of loans with similar characteristics.

This collateral pool will typically contain thousands of assets such as mortgage loans, and the interest and repayments on those assets are directed straight to investors in the bonds.

This is where the phrase ‘securitisation’ comes from – investors’ coupons are secured by the cash flowing from the regular repayments on the loans included in the pool. In other words, the credit risk in ABS transactions is limited to the quality of the assets.
 

At first glance, the ABS market can look like a confusing alphabet soup of acronyms (RMBS, CMBS, Auto ABS) but they simply identify the assets backing the bonds – for example residential mortgages (RMBS), commercial mortgages (CMBS), car loans (Auto ABS).

Why do firms issue ABS?

ABS is one way banks and other lenders fund their businesses. Their motivation for doing so is no different to that of any government or company issuing a regular bond – to borrow money against future revenues.

The difference with ABS is that it funds a specific pool of assets, and is backed by the proceeds from those assets, instead of the general financial strength of the issuing company.

For the issuer, one big advantage of ABS is that it offers ‘matched funding’ or ‘term funding’ – instead of selling normal corporate bonds to investors and then distributing the funds around the business, ABS funds a specific part of the balance sheet for a specific period of time.

For the ABS investor, the advantage is you are effectively being paid by the pool of loans backing the bond, rather than the company you are buying the bond from. If the issuing company was to go bankrupt, your coupons would continue to be paid, since the underlying borrowers in the loan pool are still making their payments each month.

How does ABS actually work?

The bonds that are sold via ABS transactions are structured into different seniority layers, or “tranches”, which each carry a certain risk and return profile based on their position in the capital structure.

A sample RMBS structure

 
For illustrative purposes to demonstrate the typical structure and not based on a particular security. Source: TwentyFour

Much like the illustration above, the highest ranked bonds (and thus lowest risk) are typically triple-A rated and pay the lowest yield but they are first in line to receive interest and principal payments from the asset pool, which flow like a waterfall down the layers.

These AAA notes are further protected by their seniority in the structure. The lowest rated tranche at the bottom is the first to absorb any losses caused by defaults on loans in the pool. Importantly, only defaults where a resulting loss occurs create an impact on the ABS deal. Loans often come with collateral like a residential home, car, commercial property or recourse to the borrower’s other assets, so a default doesn’t necessarily mean a loss for the lender.

However, structural features built into ABS to protect investors, such as a cash reserve fund that sits below the entire bond stack to help cushion against losses, make this extremely rare, particularly in European ABS.

The video below runs through how these features work in practice for a typical RMBS transaction but the same would generally apply regardless of asset pool.

Why does ABS have a bad reputation?

ABS is often cited as the chief culprit in the financial crisis of 2008, and while certain parts of the market were certainly at the centre of the fallout, we believe there are fundamental misconceptions about its role that persist to this day.

Essentially, the crisis began with weak lending standards in the US allowing some poor quality loans to be packaged into ABS products (US ABS). The prime example was mortgages given to “sub-prime” borrowers who were less likely to be able to keep up repayments through the following recession. When borrowers began to default on these loans in large numbers in 2007 and 2008 – as US house price growth began to slow – the lowest tranches of US ABS transactions backed by these mortgages began to suffer losses and their value dropped.

It was a range of other flaws in the financial system – mostly unrelated to ABS – that turned this localised US housing market slowdown into a global liquidity crisis and economic recession. Loose regulation had allowed financial firms to take on large amounts of leverage and develop a string of complex derivatives products in the early 2000s. The opacity of this system exacerbated the crisis as major global banks began to worry about their rivals’ exposure to the sub-prime market, and stopped lending to one another.

European ABS vs. US ABS

The biggest misconception, however, is that the European and US versions of ABS are the same thing. They may share the same acronym, but there are fundamental differences between the two that enabled European ABS to actually perform as expected through the financial crisis.

Realised losses on the $5.2 trillion of US structured finance¹ transactions issued between 2000 and 2008 and rated by Fitch were $195 billion, or 3.8%. Realised losses on the €2.18 trillion of European structured finance transactions issued in that period were just €8.2 billion, or 0.38%.²

Losses in the US market were ten times those in Europe. In addition, every year since 2009 realised losses in Europe have been zero, and Fitch’s expected lifetime loss rate for every European ABS issued since 2009 is also 0.0%.

There are three main features of European ABS that we believe make it more investor friendly than its US counterpart:

1. Higher lending standards – the aggressive mortgage lending practices that occurred in the US sub-prime mortgage market simply aren’t allowed to happen in Europe. Borrowers are required to hold significant equity in their property and demonstrate proof of income before loans are granted.
2. Alignment of interest – in the majority of European ABS transactions, the first loss (highest risk) tranche is retained by the issuer of the bonds. This ensures issuers have ‘skin in the game’, an incentive to make sure the deal is structured well and delivers for investors. Historically this was not the case in the US, where in the majority of deals the risk of the entire asset pool was fully transferred from the issuer to the bondholders, meaning issuers had far less interest in the quality and performance of their ABS.
3. Borrower recourse – The US mortgage market is ‘non-recourse’, which means if borrowers can no longer afford their repayments, they can simply hand the keys to the property back to the bank with no threat of further action. In European mortgage markets, the lender can continue to pursue borrowers for payments after default for a number of years (in some countries forever), leading to much lower default rates.
    

ABS by numbers

¹‘Structured finance’ includes ABS, CMBS, RMBS and structured credit

²Fitch Ratings ‘Structured Finance Losses - Global 2000-2016 Issuance’ (Jul 2017), TwentyFour

Everything you need to know about ABS

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Everything you need to know about CLOs

Collateralised Loan Obligations, or CLOs, are bond instruments issued to fund a specific pool of loans, typically senior secured or ‘leveraged’ loans, to companies. The bonds are split into tranches that can carry different ratings (and yields) according to how senior they are in the CLO’s capital structure, normally from AAA notes at the top to equity notes at the bottom.

CLOs form part of the asset-backed securities (ABS) market, which includes other securitisations such as residential mortgage-backed securities (RMBS), car loan securitisations (Auto ABS) and credit card receivables, to name just a few.

While European and US CLOs are structurally very similar, there are crucial differences between the two markets, and at TwentyFour, we have historically preferred the risk-reward profile of European CLOs when compared to their US cousins.

In Europe, CLOs represent one of the largest components of the overall ABS market, with around €180bn currently outstanding¹.

However, CLOs differ from other ABS in a few important ways. For one thing, CLOs are backed by leveraged loans, which are loans that have been made to companies, rather than the consumer loans that act as collateral in consumer ABS products such as RMBS and Auto ABS. For another, most types of ABS typically invest in assets from a single geography. For example, RMBS bonds are typically backed by a pool of home loans from a single country – not surprising since banks tend to restrict mortgage lending to domestic customers. By contrast, the market for leveraged loans is pan-European, and well diversified by industry type and maturity.

Accordingly, CLOs can spread risk more effectively than if their assets were confined to a single region, and they also represent a more diversified sub-sector of the European ABS market.

What is a leveraged loan?

Leveraged loans are essentially loans made to companies rated below investment grade. Leveraged loans can be thought of as the raw material in CLOs; it is the payments on these loans that pay coupons and principal to the CLO’s bondholders. The leveraged loans included in European CLO portfolios are normally ‘senior secured’ loans; as the name suggests, they enjoy the highest claim on a company’s assets in the event of a bankruptcy. Therefore, they are considered the least risky investment in non-investment grade corporates.

A typical loan included in a CLO portfolio generally has a rating between BB+ and B-, possesses a maturity of around five to seven years, and has floating rate interest payments indexed to Libor or Euribor.

How are CLOs managed?

CLOs are actively managed by an asset manager. The CLO manager selects a large number of loans from companies of different sizes, geographies and industries to build as diverse a portfolio of corporate loans as possible. The CLO manager can acquire or dispose of loans in an effort to optimise returns, but they are subject to several limitations regarding the asset type, quality and underlying features.

These loans are placed into a special purpose vehicle (SPV) which houses the assets so they can be administered by the CLO manager. The purpose of the SPV for European CLOs is to hold the assets and distribute interest and principal to bondholders. This also means that CLOs, like other types of ABS, are bankruptcy remote and there is no corporate risk on the lender.

Additionally, the SPV provides investors in the CLO with complete transparency, and they can see the exact details of every company in the portfolio, from its credit rating and management to the specific terms of the loan.

As a result, CLO bondholders can continually analyse the companies to which they are exposed and assess the performance of the CLO manager. They can also stress test the portfolio and run adverse scenarios in order to understand what might happen to the CLO’s returns under changing economic and market conditions.

Finally, to align the interests of a CLO sponsor with bondholders, the sponsor is required to retain a 5% minimum economic stake in the CLO. 

How are CLOs structured?

The pool of loans is the ‘collateral’ for the CLO bonds being issued. Like other forms of ABS, the bonds issued by a CLO are structured into layers, known as tranches, which typically carry different credit ratings, coupons and investor protections based on their position in the structure.

As the loans in the CLO pool pay interest and principal, this pays interest and principal on the bonds, in order of seniority. A typical CLO structure consists of different classes of rated debt; from top to bottom this is usually AAA, AA, A, BBB, BB and B rated bonds and a class of unrated equity.

The AAA note tranche at the top is the first in line for payment, while the equity note tranche at the bottom is the first to suffer any losses, which – on the rare occasion they occur – flow up the layers in the same way as payments feed down (the distribution of cash flows down the capital stack is often referred to as a ‘waterfall’). To compensate holders of the more subordinated debt, the yields offered by each tranche increase as we move down the capital stack. 

The equity tranche meanwhile is not rated, and does not have a set coupon. Instead, the equity tranche represents a claim on all excess cash flows once the obligations for each debt tranche have been met.

What can CLOs offer investors?

Investors who include CLOs in their fixed income portfolio can benefit from several unique characteristics of the asset class.

Firstly, the floating rate nature of CLO tranches reduces an investor’s exposure to short-term interest rate risk, effectively a hedge against inflation. Moreover, CLO bondholders are also protected from the consequences of rate cuts as Euribor is typically floored at 0%.

Secondly, the specialism of CLOs as an asset class means they have historically shown a material spread premium over more mainstream corporate bond markets for a given rating, an attractive trait in the increasingly yield starved world of fixed income.

Thirdly, investors holding CLOs obtain a portfolio diversification benefit, with the asset class exhibiting low correlations to investment-grade credit and equities, as well as a historically negative correlation to US Treasuries.

Finally – but perhaps most importantly – CLOs can offer far greater flexibility than regular corporate bonds, particularly when income is scarce and investors are looking to boost portfolio yield. In high yield bonds, an investor looking for more spread would normally have to buy lower rated bonds, which might mean taking exposure to a new company where the investor may not like the credit story. By contrast, all tranches of bonds in a CLO are backed by the same pool of loans, with the same performance data and the same CLO manager – if you like the BBB bonds of a CLO, our experience tells us you are likely to find buying the more junior B notes more comfortable than making the same move down the credit spectrum in high yield.

How do CLOs incorporate ESG factors?

In common with most investment products, burgeoning client demand and regulatory impetus has propelled environmental, social and governance factors to the fore of CLO markets. While the overall ESG journey for CLOs might be in its infancy, the trend is undeniable and CLO managers are adapting investment practices to factor ESG considerations in their investment decisions.

Accordingly, negative screening remains the most common mechanism utilised by ESG-conscious CLO managers, with restrictions precluding managers from investing in loans from firms engaged in specific sectors, such as tobacco, arms manufacturers and fossil fuels a common feature. According to Moody's, ESG exclusion criteria were present in 85% of EU CLOs issued since 2020. The list of exclusion is not standardised yet however more CLOs are coming with assets compliant to the UNGC principles.

That said, other approaches to ESG incorporation are becoming more common. Indeed in recent months, several well-known issuers brought ESG securitisations to market containing ESG-compliant assets and covenants referencing the UN’s Sustainable Development Goals. Furthermore, the European Leveraged Finance Association (ELFA) and Loan Market Association (LMA) have recently published best practice guides on ESG provisions in loan agreements pushing the loan market towards enhanced disclosure and standardisation.

Lastly, in addition to negative screening, some CLO managers have recently gone a step further and introduced internal scoring methodologies in order to create positive screening. 

European CLOs by numbers

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