Why are asset-backed securities (ABS) so unloved even though they offer a higher yield than corporate credits and are secured by collateral? For many investors the term ABS brings back memories of the subprime crisis in the United States and the global financial and economic crisis that followed. We believe that the bad reputation of ABS is not justified.
The structure of asset backed securities (ABS) is in essence very simple: ABS are bundled packages of loans structured in various credit rating tranches. You could compare investing in ABS with investing in a small, transparent bank with a focus on only one sector in one country. The main assets of this ‘mini-bank’ are mortgages, car loans or credit card debts and in order to finance these activities the bank issues asset-backed securities.
What happened during the crisis?
The quality of collateral is key to the quality of an ABS deal. There is nothing suspect if this collateral is of good quality, like Dutch residential mortgages. That is why European ABS cannot be compared with the mortgage junk bonds that sparked the subprime crisis in the United States. Federal policy to promote homeownership ‘forced’ US banks to extend their mortgage offering to NINJAs – people with no income, no job and assets. These subprime mortgages were subsequently repackaged and sold on. The market derailed when the US central bank raised interest rates and mortgage interest rates on subprime mortgages were raised as well: many ABS structures collapsed in the US. In Europe, however, hardly any triple A bond incurred credit losses. Not only are the rules for granting a loan much stricter in Europe, but collateral is also of a much higher quality here.
Multiple reasons to invest in European ABS
ABS is an interesting asset class for various reasons. First of all, ABS offer an attractive, solid yield. ABS pay a higher coupon yield than government or corporate bonds with a similar risk profile. Secondly, ABS provides risk diversification. A traditional investment portfolio includes asset classes like government bonds, corporate bonds, equities and commodities which offer no direct exposure to consumer risk. The ABS market provides direct access to consumer debt via mortgages, credit cards and car loans. In other words, ABS offer risk diversification opportunities.
Our portfolio offers exposure to consumers in various European countries and a wide variation in collateral. Our European portfolio is therefore far more diversified in terms of risk than US portfolios that offer exposure to US consumers only. And when we buy an ABS we know exactly what underlying class and underlying collateral we get, which is far more difficult to determine in the case of e.g. corporate bonds. We can even make an underlying risk assessment. Asset back securities are unique in terms of transparency.
The ABS strategies of Aegon Asset Management have offered an excellent return on investment in the past few years. Our longest running ABS strategy has offered an annual return of 5.85% since its inception in October 2004, which is 2.58 percentage points more than the benchmark.
Virtually all ABS are floating rate securities (with variable interest rates). The yield on ABS is based on the official interest rate prevailing plus a risk premium.
Rising interest rates
Another important feature is that virtually all ABS are floating rate securities (with variable interest rates). The yield on ABS is based on the official interest rate prevailing plus a risk premium.
Bond yields are historically low in Europe at the moment. But the economy has passed the turning point and the labour market is starting to gather steam too. It is more likely that interest rates will move upwards than downwards. In this scenario we can expect negative returns from bonds with fixed interest rates and a long duration, such as government and corporate bonds in the coming years. Asset-backed securities should offer higher coupons when interest rates rise, which means that bond prices do not have to fall.
Are ABS a good alternative for investors in search of yield?
Investors are struggling to meet their investment objectives. In the current low-yield environment ABS could be an excellent addition towards a well diversified portfolio. ABS offer extra return, but no extra risk. In our opinion ABS are just as safe as investment grade credits. Another key argument in their favour is that you have full transparency regarding the underlying investments as an ABS investor. You can even make your own underlying risk assessment, since all data are available in real-time. Aegon Asset Management uses proprietary models which are updated on a regular basis with new data.
Asset-backed securities have only one type of loan as underlying value: just Spanish mortgages, or German car loans or British credit card debt, for example. Always just one country and just one originator. So if the Italian housing market becomes more attractive than the Spanish housing market in our opinion, we can easily decide to make a switch and invest exclusively in an Italian ABS.
Are credit ratings more reliable now than before the crisis?
Rating agencies like Moody’s and Standard & Poor’s profoundly underestimated default risks before the crisis, but they learned their lesson and have become much stricter. ABS backed by Spanish mortgages, for example, cannot get a triple A rating as long as Spain itself, as a sovereign state, is not AAA. In addition, the rating agencies have a much clearer perspective now how a certain asset will behave during a severe economic crisis. The underlying tranches have to absorb a much larger part of the losses than before the crisis before the rating agencies will assign a triple A rating to the most senior tranche. Not only the rating agencies have learned their lessons, but investors as well. They are well aware now that you cannot rely exclusively on the ratings of the rating agencies.
Aegon Asset Management relies on proprietary stress test models and even calculates some sort of internal rating. These analyses are very labour-intensive, which is why there are not so many parties active on the ABS market in Europe. It takes a reasonably large team to analyse the multitude of ABS. We have been active on the European ABS market since 2004, so we have experienced and survived the hardest times, while our models have been tried, tested and adjusted over the years.
A vote of confidence from the ECB
The European ABS market has a total size of some EUR 1,200 billion at the moment. This market offers sufficient liquidity to investors, even though the European Central Bank purchased ABS for some EUR 24 billion since the end of 2014 as part of its expanded asset purchase program. In our opinion, these ECB purchases should be seen as a vote of confidence from the central bank: this asset class can indeed be considered as reliable and should deserve our trust too.