As a result of the ECB’s asset-purchase program, yields in most fixed-income classes have fallen sharply. Attractive yields can still be found in fixed income segments where the ECB has not distorted the market, such as asset-backed securities (ABS) and Dutch mortgages, according to Frank Meijer, Head of the Alternatives and Private Debt team at Aegon Asset Management.
Can fixed income markets function normally if the ECB is purchasing so much?
'Several years ago, the ECB launched a monetary easing programme on a scale never seen before which is still in force but will end at the end of 2018. As regards the public sector, the purchasing percentage is 25% and for credits and covered bonds, the percentages are 14% and 42%, of their respective eligible universe. That measure has resulted in substantial yield compression in these asset classes, particularly in traditional fixed income. But if the ECB halts its asset purchasing, given the substantial presence of the ECB in these asset classes, the yields will probably return to normal and will result in negative returns on these asset classes in the near future. Within alternative fixed income, there has been far less ECB-related involvement and the accompanying yield compression, which means that higher returns can be achieved within that category and that the future looks more rosy.'
Source: Aegon Asset Management, Barclays, ECB (as per 29 June 2018)
Do you expect interest rates to return to normal and if so, what will that mean for the expected returns?
'Yes, we expect interest rates to rise, as we have already seen in the US. In Europe, the yields are unhealthily low as a result of the ECB's asset purchases, and offer no inflation compensation. As soon as the ECB halts the purchasing programme, interest rates will probably rise. That is bad news for asset classes with a long duration. The return of these assets will be negative in the near future, maybe -5%.'
Not a positive outlook for fixed-income investors. What is your solution?
'To put it bluntly, invest in those fixed income classes where the ECB has not yet distorted the market, such as European ABS and Dutch mortgages. The yield there is still relatively attractive. The yield for Dutch home mortgages is currently 2.8%. The expected returns for ABS are between 2.25% and 2.75%, partly because ABS have a very short duration. Both fixed income classes are investment grade, so you do not have to add risk in order to achieve return. Moreover, they have interesting and unique characteristics, which means that including them in the portfolio leads to greater diversification.'
Apart from the yield, why are European ABS interesting?
'Due to the credit crisis ABS have acquired a bad name, but that is unjust. There have hardly been any defaults in Europe. The cumulative default percentage in Europe in the period between 2007 and 2017 was only 1.6%, compared with 19.3% in the US. The European ABS market differs in several respects from that in the US. In Europe, banks are almost always involved when loans are taken out. In the US, particularly in the past, many loans were handled by brokers who issued mortgages to less creditworthy people: the infamous Alt-A and subprime mortgages. In Europe, however, mortgages are issued almost exclusively to prime borrowers with a good salary and satisfactory creditworthiness. What's more, mortgage lenders in most states in the US have only a claim to the house in the case of payment default. They cannot claim other possessions or current or future income of the borrower. As a result of these two differences, the losses on mortgages in the US – and therefore ABS bonds covered by these mortgages – were far larger than those in Europe. We have never had a default in our European ABS funds, not even in the period from 2007 until now. Because of spread widening, the return in our European ABS fund was -14% in 2008 and -2.5% in 2011, but even so, that return was more positive than in many other asset classes in those years. In our opinion, ABS has therefore unjustly acquired a bad name. There is a real difference between US subprime ABS and European ABS.
European ABS are attractive for two other reasons. An interesting characteristic of European ABS is that they have floating rates coupons. In the case of any interest rate rise, the ABS bond coupons rise in parallel and the market value remains stable. This can be very attractive to clients who expect interest rates to rise. Finally, ABS contribute to diversification within the portfolio. The collateral often consists of mortgages or car loans. It therefore involves consumer risk, rather than corporate risk or government risk. In Greece, a similar diversification has had a positive effect. Greek government bonds were largely written off, but ABS bonds covered by Greek mortgages were all repaid without loss.'
In conclusion, the advantages of Dutch mortgages are:
The ECB has purchased only liquid assets – with a rating and an ISIN – as part of its asset-purchase programme. As a result, the yield on liquid assets has fallen sharply. Although the Dutch mortgage interest rate has also fallen, the yield on illiquid Dutch mortgages is still very attractive. The gross return amounts to approximately 2.8% and the write-offs have always been very low – no more than a few basis points per year – due to the proper payment behavior of the average Dutch citizen.
Our strategy involves a mix of NHG (National Mortgage Guarantee) and non-NHG loans. More than half of the mortgage loans provided have a maturity of between 16 and 20 years and more than a third have a maturity of between 21 and 30 years. This long duration is attractive for covering long-term liabilities of institutional investors, such as pension funds, insurers and life insurers. Furthermore, mortgages also work favorably in the context of the Dutch Financial Assessment Framework (FTK) and the Solvency II Directive. This has led to greater inflows in our mortgage fund, not only from Dutch clients, but also from growing numbers of foreign institutional parties. In our strategy, the mortgages are issued by Aegon itself and Aegon Asset Management uses them as an investment tool. This provides a satisfactory alignment of interests, which many clients appreciate.'