Quality yield comes in many forms. Since early in the year, we have been advocating an up-in-quality stance for risk assets given mounting headwinds in the broader investment landscape. While relatively niche compared to traditional equity and fixed income classes, securitised debt markets are still a viable means of obtaining stable income with quality enhanced by tranche structuring, providing risk mitigation through diversification, and waterfall structures. Due to its relatively small size and perceived complexity, the asset-backed securities (ABS) space is often overlooked, but characteristics of (a) high cash flow visibility, (b) low interest rate sensitivity, and (c) low default risk warrant it a closer look given the macro uncertainties clouding the outlook today.

Figure 1: US asset-backed securities provide competitive yields with low duration

Source: Bloomberg, DBS

What are ABS? ABS are financial securities backed, or collateralised, by contractual cash flows from a pool of cash-generating assets which could be private equity, mortgages, commercial loans, auto loans, student loans, credit card receivables, etc. This pool comprises the same type of assets, involving numerous and diverse payers (e.g. a credit card ABS trust might contain receivables from thousands of individual credit cardholders, while an auto loan ABS trust would contain receivables from thousands of car loans). The inclusion of numerous receivables provides diversification that minimises idiosyncratic risks associated with the individual payers.

A special purpose vehicle (SPV) purchases these assets from the sponsor and simultaneously issues securities to fund its purchase of these assets. This single homogenous pool is then securitised, and quite normally, split into different tranches of varying seniority. The most senior tranches are first in line to receive cash flows from the underlying – cushioning investors against losses but offering the lowest yield, while junior or equity tranches give the highest yield but are most risky since they are first to absorb any losses from the pool. In this way, securities that suit different investor risk and reward preferences are created from one single pool of assets.

Benefits of investing in ABS. Investors in ABS stand to benefit from the following:

• High credit quality – Securitisations are designed such that the most senior tranche is exposed to minimal credit risks and can withstand losses multiple times what is expected from the underlying pool. The safety of senior tranches is engineered through credit enhancements. Examples of credit enhancements include subordination of junior tranches or overcollateralisation (issuing less securities than the value of the collateral). These provide a safety net such that senior tranches are often endorsed with investment-grade ratings, in many cases rated AAA.
• Diversification – ABS structures offer different types of underlying collateral pools ranging from corporate to consumer loans. This offers potential diversification benefits since consumer-related receivables are exposed to credit performance of consumers, offering a different risk profile to bonds, which are usually exposed to corporate credit risks.
• Stable cash flows – Since the underlying assets represent a diversified pool of periodic contractual payments, this offers investors predictable and stable cash flows.
• Higher spreads – To compensate investors for the additional complexity of ABS structures and lower liquidity, ABS are known to offer more generous yields than bonds in the same rating category, giving investors an attractive risk-adjusted return.
• Lower duration – Consumer-related credit such as credit card receivables tend to be based on floating rates and/or have much shorter in maturities than corporate bonds, resulting in ABS generally having lower sensitivity to rising interest rates.
• Insulation from sponsor’s credit risks – ABS investors are protected from credit risk or any potential financial distress of the sponsor, since the SPV issuing the securities is a legally distinct from the sponsor. Repayment of the underlying loans depends on receipt of contractual cash flows from the payers which is independent of the sponsor.

Risks of investing in ABS. There are, however, unique risks to ABS that investors need to keep in mind:

• Liquidity considerations – Due to their smaller market size, ABS markets tend to be less liquid than more established fixed income categories. Hence, investors would do well to consider their investment horizon vis-à-vis the maturity of the instrument and the expected liquidity of their secondary market.
• Complexity – Securitised products have complex structures involving different layers of legal entities and detailed documentation, since securitisations usually involve multiple tranches with different profiles. Furthermore, ABS reporting differs from the usual financial disclosures of corporates that investors might be more familiar with. This could prove daunting especially for first-time investors without the benefit of trusted financial advisors.
• Prepayment risks – This refers to the risk that payers pay more than their periodic contractual requirement, lowering the interest income generated by the pool of assets. While prepayment risk could be significant for structures with longer-term underlying assets, it is generally low for shorter-term loans common amongst consumer payers.
• Systemic risks – Although collateral pools mitigate against individual payer-specific risks, it is important to note that the addition of numerous payers does not diversify against systemic risks. For example, securities issued against a pool of mortgages would be exposed to risks in the real estate market i.e. macroeconomic shocks would lead to highly correlated losses. Many would recall the 2008 collapse of the US subprime mortgage market in which falling house prices led to systemic defaults across mortgage pools – amplified by derivatives – unearthing risks in MBS structures that were understated by credit rating agencies.

Capitalising on strong consumer balance sheets. Within securitised markets, consumer-related segments in particular could offer attractive opportunities, considering that household balance sheets appear poised to weather the storm ahead, having strengthened considerably over the past decade. Investors bracing for uncertainty in the road ahead would find opportunities in consumer-related securitised structures, of which senior tranches provide high credit quality at lucrative yields. Even if cash flows from the underlying collateral pool were to weaken under the pressure of macro headwinds, the senior tranches are likely to remain cushioned by any loss absorption in the subordinated tranches.

 

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