Asset-Backed Bonds Are Getting Too Rich for Some Investors' TastesBy
Spreads expected to reach fresh post-crisis tights in 2018
Rising rates and macro risks are main worry for ABS investors
When bond spreads are tight across the entire risk-asset spectrum, investors typically crowd into to structured-finance bonds such as consumer asset-backed securities (ABS) to eke out more yield or earn carry. That may not be the case anymore.
ABS in the U.S. have had a banner 2017, and the good times are expected to roll through next year. But with the expectation that spreads across ABS sectors will continue narrowing to record-tight post-crisis levels in 2018, investors are beginning to wonder whether these bonds still makes sense, especially in light of credit risk in some asset classes.
“This spread tightening in ABS could last for another six to 12 months," said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management, a fixed income manager and adviser with more than $24 billion of assets under management. “Many banks and issuers are of the mindset that they want to keep dancing while the music is playing.”
As a result, it’s getting harder for investors to find value. For example, the AAA-rated slice of a subprime-auto bond from GM Financial priced at 18 basis points over Libor last month, down from 38 basis points for a similar bond a year earlier.
A smaller issuer in the same sector, Flagship Credit, priced at 35 basis points over a fixed-rate benchmark in November, compared to 68 basis points for a similar deal in January.
Meanwhile, a student-loan ABS from Sallie Mae Bank tightened to 27 basis points over a benchmark for the AAA tranche of an October deal, down from 55 basis points over for a similar slice of their year-ago trade.
"Spreads will get tighter for awhile," said Ken Purnell, head of ABS portfolio management at Invesco. "The macro view is very positive and is supportive of spreads remaining low."
ABS spreads will hit new post financial-crisis tights in 2018, after rallying this year to the tightest levels of the past decade, say JPMorgan research analysts.
“Consumer and credit fundamentals are sound, ABS structures and credit support are robust, and technicals remain supportive as the ABS market heads into 2018,” analysts Amy Sze and Ashin Shah wrote in a November 22 outlook note.
Worth the Risk?
Investors have historically been drawn to ABS in search for incremental yield when global rates are low. They like the sector’s short-duration bonds, generally high ratings, and the fact that a large portion of the market is floating-rate and amortizing, providing opportunity to reinvest at higher rates.
But as consumer ABS bonds get richer, investors have had to work harder to find attractive relative value, especially considering growing risks in sectors such as subprime auto.
"We’re not necessarily forecasting a recession or a slowdown, but are concerned that we’re not being adequately compensated for risk-taking in certain areas," said John Carey, head of structured securities investments at BNP Paribas Asset Management, who invests in spread sectors to earn extra carry. "It’s a time to be nimble and tactical."
"There’s not a lot of value there," Merrill said. "At this point in the credit cycle, we have a preference for cleaner structures and higher-quality borrowers, further up the capital stack.”
Purnell says he’s concerned about where spreads are in the historical spectrum and how tight they are across all investment-grade assets. "We’ve seen periods where investment-grade spreads are very tight and remain very tight for several years at a time," he said.
As global central banks pull back from years of easy monetary policy and begin unwinding balance sheets, the question is, when will the music stop?
Investors are keeping an eye on rising delinquencies in subprime auto, marketplace lending and unsecured consumer loans. They don’t deny that there is weakness in these asset classes, but most buyers have faith in ABS structures and their built-in credit enhancements.
"I’m not worried about consumer balance sheets, as there has been a significant amount of household deleveraging since the crisis. Households have never been in a better position," said Tracy Chen, the head of structured credit at Brandywine Global Investment Management, which oversees $74 billion. "The economy recovery and job growth look good as well. What I’m most worried about is a macro hiccup."
Chen’s main concerns are geopolitical risk, the stability of the U.S. administration, North Korea, normalization of the Fed balance sheet, potential Chinese economic slowdown and inflation.
"If inflation picks up, it may accelerate the pace of the Fed’s interest-rate tightening, which could make the next recession happen sooner than expected," she said.
In fact, timing of the global wind-down of accommodative monetary policy and the unwinding of central-bank balance sheets may be among the top concerns of ABS investors as they head into 2018.
"G4 central bank balance sheets have continued to expand. But we think the ECB will stop buying bonds later on in 2018," said BNP’s Carey. "Given that all that bond buying fueled these tight spreads, now that central bank intervention may begin to wane, people are wondering, what are the implications for risk assets?"