The case for investment grade ABS An M&G Investments institutional perspective

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1 Spread (bps) For Investment Professionals only The case for investment grade ABS An M&G Investments institutional perspective February 2016 The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. Investment grade, A to BBB-rated European ABS, has in our view become an overlooked part of the market that can offer much higher returns than its credit fundamentals imply. This area has been squeezed by two rival investment strategies as most market participants seek either AAA to AA-rated paper as a safe, low-yielding alternative to government bonds and cash, or non-investment grade ABS which can offer a pick-up to high yield bonds. It consequently offers an attractive entry point with prospective returns in the mid-single digits (5 to 6 over Euribor or Libor) for an average A- to BBB+ rated portfolio. Investment and issuance dynamics in the European ABS market have led to the emergence of considerable relative value in A to BBB rated investment grade securities. Spreads on these ABS have widened over the past six months as investors focus on either top-rated ultra-safe securities or low-rated paper offering high single-digit returns. Caught between these divergent sets of investor expectations, A to BBB-rated investment grade ABS are neither sufficiently highly rated to be considered by those looking at the lowest-risk securities, nor do they offer enough headline yield to satisfy investors seeking high single-digit returns Spreads on BBB rated investment grade European ABS have widened 0 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 UK RMBS AAA 5y GBP Source: M&G, J.P. Morgan ABS weekly spreads, data as at 11 February 2016 Yet the fundamental drivers underlying this part of the ABS market remain solid. The historical credit performance of investment grade European ABS is strong while net supply is negative as repayments and redemptions exceed new issuance both of which should lead to spread tightening, all other things being equal. We therefore believe the returns on offer attractive compensation for risk. Market contraction exposes investment opportunities UK RMBS AA 5y GBP The volume of outstanding European ABS has declined steadily since the onset of the financial crisis as supply of new issuance has been dwarfed by maturities and redemptions. New issue volumes of around 85 billion in 2015 were more than offset by more than 100 billion of repayments, according to Standard & Poor s (S&P). By January 2016 the European ABS market had shrunk to an estimated 500 billion, according to Nomura, from more than 2 trillion in mid-2007 as estimated by S&P.

2 Gross issuance ( 000s) The largest and most recent example was the redemption at par in December 2015 of 7.5 billion of Granite, the former Northern Rock prime RMBS master trust nationalised by the UK government at the height of the financial crisis. Interestingly, despite the nationalisation not a single Granite bond defaulted or was impaired during the ten+ years the programme was outstanding. The lack of (net) new issuance has two main causes: regulation and cost. Stringent new financial regulation introduced in the wake of the financial crisis, and particularly the Solvency II framework for European insurance companies, has imposed high capital charges on ABS versus similarly rated covered, corporate or financial bonds. Regulation has made it extremely difficult to grow a new real money investor base to replace the largely levered investors that came to dominate the market by mid It has also made ABS an expensive route for banks to fund themselves compared with covered and unsecured bonds, further incentivising issuers to opt for lower-cost alternatives. European policymakers have become increasingly clear about the need to revive the ABS market, given the vital role securitisation plays in allowing banking groups to borrow against their loan books and transfer risk off their balance sheets. The European Central Bank (ECB) has publicly called for an easing of the regulatory environment for ABS to improve both demand and supply 1 and since late 2014 it has implemented an ABS purchase programme to buy paper in both the primary and secondary markets. However, a revival of the European market is unlikely until regulatory capital and liquidity charges are improved to enable banks and insurers to hold securitisations. While progress is being made through initiatives such as the creation of an EU-wide framework for simple, transparent and standardised securitisations (STS), it has been slow to date. The ECB s ABS purchase programme also significantly underwhelmed the market in 2015 with total acquisitions of just over 15 billion, which has left many would-be entrants disappointed. As such, we support estimates from groups such as JP Morgan, Deutsche Bank and Morgan Stanley, which anticipate new issuance of no more than 90 billion for 2016, which again is likely to be more than offset by expected scheduled redemptions and maturities. The lack of new issuance compared with pre-crisis volumes is starkly illustrated in the graph below: 450, , , , , , , ,000 50,000 0 European ABS issuance remains far below pre-crisis levels RMBS - Prime RMBS: NC and buy to let CMBS Consumer SME Autos CLOs Other Source: M&G, Nomura, as at 31 December

3 Tight supply favours experienced managers Importantly, the chart shows new supply is increasingly dominated by the highest rated ABS i.e. AAA-rated which is the cheapest to issue. The replacement of the A to BBB-rated part of the capital structure, as it repays over time, is consequently even more limited. This creates an interesting market-supporting dynamic for potential investors in this area, since if spreads remain wide or widen further there is still less chance of new issuance emerging, which could lead to even greater shrinkage in supply. Outstanding non-aaa European ABS are also repaying more slowly than AAA-rated tranches, which are the first to be paid down as the underlying collateral matures or repays. Within A to BBB-rated European ABS, the sequential nature of amortisation in many older transactions that have not yet matured is resulting in a far less pronounced pace of decline than in AAA paper. Despite this, only about 131 billion of A to BBB-rated European ABS is still outstanding, according to Nomura estimates in January 2016, down from a peak of more than 350 billion in mid And while non-aaa primary tranches are still issued from time to time in areas such as auto ABS, UK RMBS, CMBS and CLOs, they are relatively infrequent and tend to be heavily over-subscribed, particularly for better-quality transactions. Intense competition for limited supply requires investment managers to have a strong market position and well-established relationships with issuers in order to achieve better than straight-line allocations. We have seen this part of the market reopen over the past 18 months, particularly in the UK, and while issuance remains on a relatively small scale we are being shown sufficient attractive investment opportunities to build a diversified portfolio. Liquidity in this area of European ABS also continues to be more than adequate for a manager with deep asset-sourcing networks, despite the overall decline in market size. Attractive historical default rates The widening of spreads in A to BBB-rated investment grade ABS in Europe would be more easily explained if historical default rates were abnormally high. Yet their default performance dating back to the 1990s has been perfectly satisfactory for their place in the capital structure, as illustrated below. We believe it is simply a combination of over-zealous regulation and nervousness in the market due to the performance of US sub-prime RMBS in the crisis that keeps spreads at the current levels in Europe. The table below shows the historical five-year ratings transition in EMEA non-cdo structured finance bonds for the past 20 years, demonstrating, for example, that a bond that was originally A rated had on average a 1.51 chance of becoming impaired over five years. EMEA ABS, CMBS and RMBS five-year rating transition matrices by cohort rating, 1993 to 2014 Average counts Aaa Aa A Baa Ba B Caa Ca-C Withdrawn Impairment Aaa Aa A Baa Ba B Caa Source: Moody s structured finance ratings transitions, , data published September 2015 We view these impairment rates as very favourable given the time frame the financial crisis default spike from 2007 to 2009 represents three of the 20 years covered by the data as well as the diversity of the EMEA market. For instance, Moody s does not break down this data further, but in our view CMBS is the

4 major contributor to these impairment rates, since an S&P study in 2014 calculated that consumer-related securitisations in Europe experienced cumulative default rates of just 0.05 between 2007 and A large percentage of impairments in lower tranches of the capital structure are also likely due to southern European ABS, which represent a significant proportion of EMEA securities caused by the relative size of the Italian and Spanish RMBS markets. We continue to see limited relative value in southern European ABS, in part due to the distorting impact on spreads of the ECB s purchase plan in peripheral European Bonds. Additionally, impairment is not the same as default, as it includes ABS that had not paid interest for 12 months, i.e. those downgraded to below Caa to CCC as well as those in default. There are many instances in which ABS have become impaired but subsequently become current again as their collateral quality improved. Moody s also published an analysis of EMEA structured finance impairments in 2014, which reported a 12-month impairment rate of 0 for all investment grade categories and Ba rated credits across all areas of EMEA structured finance from CMBS to CLOs. Given this data again includes assets downgraded to below CCC (even temporarily) as well as defaults, and includes stressed markets such as Greek ABS, we view this as an extremely strong performance that illustrates the credit stability of this asset class in Europe. A lack of published data for EMEA corporate bonds over the same time series prevents us from comparing these figures like-for-like, but Moody s has produced average five-year default rates for global corporate bonds for the much longer timeframe between 1970 and 2014, below: Aaa Aa Average global credit five-year letter rating migration rates, A Baa Ba B Caa Ca-C Withdrawn Impairment Aaa Aa A Baa Ba B Caa Ca-C Source: Moody s corporate default study 2014, data published March 2015 This second dataset reflects a much smaller effect from the financial crisis. The jump in defaults was experienced by all credit markets, but only represents three years out of 44 in the global corporate bond series, so would have a more modest overall impact. We additionally note that the withdrawn column incorporates all bonds that were repaid or redeemed before their maturity date. For almost all ABS this would mean the bond was repaid. However, for corporate bonds this would typically be caused by mergers, takeovers or take-private buyouts, which due to the boom in the leveraged buyout market in 2014 and 2015 has often resulted in entities moving to sub-investment grade. Rethink on ratings External credit rating agencies significantly tightened their ratings criteria for ABS in the wake of the financial crisis after coming under heavy criticism for their assessment of US sub-prime securitisations. During the subsequent Eurozone sovereign debt crisis the major agencies also adapted their sovereign ratings caps for individual structured finance ratings, to prevent any securitisation benefiting from a much higher rating than that of its sovereign. These two changes alone resulted in a huge volume of downgrades for European ABS, even though there had not necessarily been a material underlying deterioration in performance.

5 Repossession rate (percentage points) Average UK house price ( ) There is now growing acknowledgement that this approach may have been overly conservative. In December 2015 Fitch revised its residential mortgage criteria and placed 533 tranches of UK RMBS on credit watch positive 2 ; Moody s also upgraded 196 notes across 64 UK non-conforming RMBS in the same month in light of better collateral performance. Rating upgrades have been much more common than downgrades in European ABS in recent years and we expect this trend to continue. So while we cannot exactly compare European ABS and corporate bonds like-for-like, all other things being equal we believe evidence from both historical impairment rates and the changes made to ratings by external agencies points to very similar default rates in both. Yet a typical European ABS portfolio with an average A- to BBB+ rating can target an expected return of 5-6 over Euribor / Libor, whereas a typical corporate bond portfolio with the same rating would likely target a 2-3 spread on a similarly floating rate basis (after taking into account the cost of swaps). In our view the considerable extra return offered by European ABS more than compensates the holder for any additional credit risk that may exist versus corporate bonds. As an alternative approach, a corporate bond portfolio intending to target an expected return of 5-6 over Euribor / Libor would likely have an overall sub-investment grade rating. As the global corporate bond data series shows, for high yield ratings bands the observed five-year average default rates have been around 7.6 per annum for the past 44 years more than twice the five-year average default rate of BBB rated EMEA ABS in the past 20 years. Why has European ABS proved so resilient? A stress test of non-aaa investment grade UK RMBS Sensitivity of UK non-conforming RMBS to UK housing market stress Q peak average UK house price of 184k 7.1 rise since earlier peak in Q , , , peakto-trough drop of peak repossession rate of 0.79 p.a. Modelled 50.0 peak-totrough fall in prices Tranche C breakeven modelled 4.51 repossession rate for 16 quarters and then a long term rate of , , ,000 80,000 60,000 40, ,000 Historical repossessions (CML) Nationwide Average House Price C Tranche (A) House Price Stress Source: M&G, Trinity Square UK non-conforming RMBS issued by Kensington Mortgage Company, December 2015 (TRINI ), Nationwide (house prices); Council of Mortgage Lenders (repossession data); as at 31 December We analyse the resilience of our RMBS holdings by modelling the impact of extreme scenarios on the performance of the underlying mortgage loans. The chart above illustrates what would have to happen 2

6 before investors in the A rated C tranche of this UK non-conforming RMBS lost their first Euro of investment. It shows that investors would still break even in a situation in which the UK housing market underwent an unprecedentedly deep and long-lasting collapse. Our cashflow model concludes that even if UK house prices fell 30 overnight and never recovered, annual underlying borrower defaults would have to rise to above 7.5 per annum for four consecutive years before reverting to a long-run default rate of more than 1.5 per annum before an investor lost their first Pound on this bond. If all of these defaults are added together, this implies that almost 50 of the loan pool would have to default over the life of the transaction (it matures in 2028) at the same time as house prices fall 30 in the UK in order for this tranche to incur a loss. When one considers that current default rates are significantly less than 1 per annum, it would obviously require an extreme, multi-year depression scenario to even reach this breakeven point. We therefore consider bonds such as this to be highly resilient to stressed situations. Yet this bond, which is rated A+ / A2 by S&P and Moody s, could be bought at a spread of basis points over Libor / Euribor in early February 3. An attractive outcome In a long-term low interest rate environment, the search for yield becomes ever more pressing, but many asset owners are rightly cautious about chasing returns, particularly at times when fears about economic slowdown are being voiced and may signal increased financial pressures. We believe A to BBB-rated investment grade European ABS can help to address these dual challenges by offering attractive target returns from a market segment with low, if poorly understood, historical default rates and without having to materially increase exposure to non-investment grade risk. The European ABS market also benefits from being reasonably liquid. M&G and European ABS We have always invested in European ABS across the full capital structure both for our parent and thirdparty clients, mandates permitting, and our holdings now stand at more than 20 billion. These aggregate holdings have always been dominated by AAA paper, which represents roughly 75 of the total, as AAA buyers tend to use the market as an alternative to cash or government bonds and so naturally put larger sums of capital to work. The ABS portfolio management team invests just over 5 billion of M&G s total ABS holdings and the team raised a further 1 billion across our ABS strategies in More than 90 of the ABS portfolio management team s assets are managed on behalf of external clients. The non-aaa investment grade segment of our aggregate ABS holdings remains sizeable, as in the first years of the financial crisis M&G sought to capitalise on dislocation in this part of the market that had been caused by indiscriminate selling. Not only were prospective IRRs clearly much higher than on AAA-rated securities, we believed good-quality A and BBB paper could withstand even a severe depression from a stress resilience standpoint, as illustrated previously. We continued to focus on this strategy until mid-2014, when in our view spreads became too tight relative to other areas of the market such as both high grade and non-investment grade ABS. We then began liquidating these positions. Our ABS-specific strategies are now primarily focused on AAA and high grade (AA to A-rated) funds and mandates as well as a significant portion of non-investment grade investments, as we have seen more pronounced relative value in these areas. 3 Source: Bloomberg, as at 8 February 2015

7 Investment in European investment grade ABS has been hindered by a lack of primary supply of A to BBB-rated RMBS, CMBS and other non-clo asset classes. However, we believe our longstanding market position and deep network of relationships among issuers and intermediaries enables us to construct a diversified portfolio once again from new primary market supply without relying on older transactions from 2008 or earlier. Given this issuance trend and the current favourable moves in spreads, we believe the non- AAA investment grade part of the market offers compelling relative value and the time is right to re-enter.

8 About the authors: James King Director of Fixed Income James joined M&G Investments in 2003 as a fund manager within the Alternative Credit group and is responsible for the ongoing development of our ABS business. Prior to M&G, James worked for Citigroup, initially in the corporate bank and, latterly, in the alternative investments group as portfolio manager and credit analyst focusing on asset backed securities and industrials. James graduated from Durham University with a degree in Business Economics. Patrick Janssen Portfolio Manager Patrick joined M&G Investments as a Portfolio Manager in ABS in September He currently manages a mix of different ABS mandates. Prior to joining M&G Investments, Patrick worked at Fortis Bank as a Senior Credit Manager in ABS. His prior work experience involved US stocks and real estate analysis. After graduating with honours from Antwerp University as a Commercial Engineer, he specialised further in Fiscal and Financial Sciences and became a Certified International Investment Analyst (CIIA). For more information contact: Andrew Swan +44 (0) andrew.swan@mandg.co.uk John Atkin +44 (0) john.atkin@mandg.co.uk Annabel Gillard +44 (0) annabel.gillard@mandg.co.uk Henry Barstow +44 (0) henry.barstow@mandg.co.uk Sunita Dey +44 (0) sunita.dey@mandg.co.uk institutional.clients@mandg.co.uk The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. For Investment Professionals only. This guide reflects M&G s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 0635/MC/0615_UK MDII