A lot of investors have been increasingly concerned about the deteriorating quality of subprime auto loans. (See here, here and here.)
But there's one important group that doesn't seem particularly worried: buyers of bonds backed by these loans. These investors seem downright happy. They're reaping substantial returns, earning their coupons and watching the value of the securities increase this year.
And in an odd twist of logic, the ratings of these subprime securities backed by auto debt are steadily improving even as more American borrowers fail to meet their monthly obligations. So far this year, S&P Global Ratings has upgraded 139 tranches of securitizations backed by auto debt, including 99 slices of debt backed by subprime loans, according to Vishwanath Tirupattur, a Morgan Stanley strategist.
That doesn't mean there aren't serious problems in the subprime auto-loan universe. There are. The total amount of subprime auto loans has risen substantially in recent years, with so-called deep subprime borrowers accounting for more of the debt. Borrowers are obtaining loans for longer periods than they used to, which is becoming more of a liability as auto resale values decline. Auto-loan defaults are surging to highs last seen in the wake of the 2008 financial crisis. Losses are mounting.
All that said, debt investors know that and are asking more from the underwriters of securitizations backed by auto loans. They've demanded that a bigger pool of loans back the top-rated securities, and each borrower is paying a much higher interest rate, 23 percent or higher. So even if many of the consumers end up failing to make their debt payments, holders of upper-rated bonds will most likely get their money back. Consequently, they are demanding less extra yield.
As Morgan Stanley analysts noted in a May report, "Relative to subprime, prime deals appear to have less protection." In other words, upper-rated securitizations of subprime loans have much bigger cushions of paying loans that all need to default before the notes experience losses. Investors seem to be realizing this, at least based on the disproportionate gains on top-rated bonds backed by subprime auto loans this year relative to those backed by prime loans.
Of course, the continuing struggles in the subprime auto-loan market will cause some distress. Investors have had a rocky relationship this year with the unsecured debt of lenders that cater to a big proportion of subprime borrowers, such as Capital One. And don't forget about the consumers, who are either stuck paying tremendously high rates or else face having their credit lines cut off and their cars repossessed.
And the lowest-rated pieces of these securitizations won't necessarily be immune to the continuing weakness in the underlying loans. But the split fortunes of different credit investors show how much debt structure matters. Higher-rated bonds backed by subprime auto loans are like an island in increasingly choppy seas.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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