Demystifying European Asset Backed Securities July 2017
2
We are fixed income specialists it is the only asset class we cover. Our focus is on preserving our investors capital and taking advantage of capital growth opportunities in the right market conditions. Our team of 45 staff consists of 19 investment professionals with on average 18 years experience. They are led by twelve partners who each have a significant stake in the business and on average, 23 years investment experience. Our team members hail from a wide variety of fixed income disciplines. These include working in portfolio management, banking, trading and rating agencies, which gives us a more holistic view of the market. Our team remains close to the market by conducting their own trading. We consider this to be vitally important in a world where liquidity and trading costs are key concerns. TwentyFour is a leader in the ABS industry, with nine investment professionals. This represents one of the largest pools of talent in the industry dedicated to European ABS. TwentyFour s experience in ABS goes back a long way to 1989 when Rob Ford, then at Barclays Bank, issued the first European securitisation. Prior to joining TwentyFour Asset Management, Ben Hayward managed Europe s largest ABS funds. TwentyFour went on to launch the first dedicated retail RMBS fund in 2009 and then launched the first dedicated listed European ABS fund in 2013. Since its foundation in 2008, TwentyFour and the ABS team have won numerous awards and regularly train and advise sovereign institutions on fixed income and ABS. 3
Demystifying European Asset Backed Securities Income is hard to come by these days. Ultra-low interest rates have meant that previous sources of income have become increasingly elusive. That is why asset backed securities (ABS) once shunned in the wake of the financial crisis are now back in favour. They are one of the few types of bonds which are able to deliver an attractive return today. This is particularly true for Europe, where the ABS market is characterised by solid fundamentals, high underwriting standards and attractive spreads. It s an under-researched area of the market, providing good opportunities for income-seeking investors. In this paper, we will try to demystify European ABS. First we explain how ABS work, their investment characteristics and how European ABS differ from both US ABS and senior loans. We then go on to discuss how European ABS can fit into a fixed income portfolio and why it s an attractive investment. AT A GLANCE ABS are mainly floating rate securities, which have near-zero interest rate risk. ABS provide higher yields than traditional fixed income instruments for a given rating. They are issued by financial institutions as a treasury funding tool and in some cases can offer capital relief. ABS enable investors to gain exposure to a pool of specific assets and are structured to provide attractive defensive risk characteristics. European ABS are fundamentally different to US ABS, with higher lending standards, and recourse to the original borrower. Historically, expected cumulative lifetime loss rates are 0.88%¹ for the entirety of European ABS, whereas US loss rates are 7.3%. 2 ABS offer significant advantages over senior secured loans, with collateralised loan obligations enabling higher yields with lower risks than similar senior secured loans. It is an opportune time to invest in ABS, given attractive yields, improving fundamentals, limited supply and potential for capital gains if spreads tighten. HOW ABS WORK ABS are backed by a specific pool of financial assets. For instance, these can be credit card loans, auto loans or mortgage loans. Just like corporate bonds they pay interest periodically on a defined basis. The difference is that these interest payments are not usually fixed rate. They typically offer a margin over a floating rate index such as 3 month GBP LIBOR or 3 month EURIBOR the rates that banks lend to one another. However, just like all fixed income products, they pay the principal back at maturity. A special purpose vehicle (SPV) is the legal entity used to issue ABS bonds, also known as securitisation. The SPV buys a pool of loans or other assets from a financial institution, such as a bank or building society. The SPV then issues bonds to end investors. Then the underlying assets in the pool then pay the coupon on the bonds (See Figure 1 below). These bonds are known as Asset Backed Securities or ABS because they are secured on the specific pool of collateral held by the SPV. WHY ISSUE ABS? ABS are typically issued as a funding tool for the sponsoring entity. For example, a bank will issue mortgage backed securities to fund a specific pool of mortgages. In limited scenarios the sponsor will be able to claim capital relief, provided the sponsor can meet certain accounting and risk-transfer conditions, although following changes to regulations in recent years this is rare. As ABS are generally only used as a funding tool, they make up part of the sponsoring entity s treasury funding options. For a bank, ABS can sit alongside deposits, covered bonds, senior debt and other bonds as a way of obtaining leverage on their capital. Figure 1: ABS issuance and cash flows Sponsor e.g. Bank A Sells loans and assets ABS issuance proceeds SPV Bank A Mortgages 2016-1 Issues ABS Buys ABS ABS Investors 1 EMEA Structured Finance Losses 2000-2016, Fitch Global, 19th July 2017 2 Structured Finance Losses 2000-2014, Fitch Global, 7th February 2015 4
There are many different types of ABS that investors can choose from, backed by different types of assets with slightly different characteristics. Some of these differences are highlighted below in Figure 2. Yield and risk characteristics of each type of ABS vary widely depending on the combination of underlying assets, rating, collateral and structure so it is difficult to provide general ranges per type of ABS. That said, as an illustration, at the tight end of the market both Dutch triple-a prime mortgage ABS and German triple-a auto loan ABS are trading at around 15-20bps over EURIBOR, whereas single-a rated CLOs and non-prime RMBS offer spreads around 320bps, rising to 175-200bps as ratings reduce to single-b in PLOs. 3 Note that although the rest of the paper uses examples involving RMBS, the principles outlined apply to all of the above types of ABS. WHAT DO THESE ABS ASSET POOLS LOOK LIKE? They typically focus on assets from a: Single geography i.e. the Netherlands or Spain Single type i.e. residential or commercial mortgages Single originator i.e. a bank such as Santander or Barclays The exceptions here are CLOs and CMBS where a blending of geographies may occur. Another key difference to other asset classes is that ABS issuers produce reports which show how loans within each of their pools are performing. This enables experienced managers to accurately analyse and value ABS, as well as enabling ABS buyers to ensure they only gain exposure to the specific markets and assets, thus avoiding exposure to segments and assets perceived as undesirable by the manager. ABS is a niche, complex sector and therefore not highly researched, which enables expert managers to consistently find value. WHAT DOES THE CAPITAL STRUCTURE OF A TYPICAL ABS LOOK LIKE? ABS deals typically issue multiple bonds that are tranched into different currencies, maturities and most significantly, seniority. This is the key difference between ABS and other structures. It means that the cash flows from the underlying asset pool is used to pay the ABS tranches in turn, from senior to junior. Thus the cash flows appear to flow down the ABS structure, as shown in the diagram (Figure 3) overleaf. Similarly, defaults flow up the structure. This pooled structure means that the risk associated with holding a given tranche of ABS depends primarily on the quality of the collateral and the probability of default in the underlying asset pool. If there are defaults then the seniority of the tranche in the ABS structure comes into play. Thus, senior ABS at the top of a structure may be rated triple-a, while the more junior mezzanine tranches may be rated double- or single-b. To compensate investors for the risk they take, junior tranches will offer higher returns than more senior tranches. An investor can then purchase the tranches they need to satisfy their appetite for risk and yield. In addition, ABS investors benefit from three types of protection. Figure 3 overleaf explains how this works using residential mortgage backed securities as an example. A similar approach is used across other types of ABS, wherever the ABS is secured on an asset, such as Auto loans or Commercial Real Estate transactions. For unsecured lending such as credit card receivables the borrower equity concept does not apply. Figure 2: Different types of ABS Type Description Volume 2 Residential mortgage backed securities (RMBS) RMBS are pools of mortgage loans created by banks and other financial institutions. They represent the largest component of the European ABS market and are the most liquid. 699.5 bn Consumer receivables Consumer receivables include a large variety of unsecured consumer debt types that have been securitised including auto loans, credit card receivables and unsecured personal loans. 206 bn Commercial mortgage backed securities (CMBS) CMBS are mortgage backed securities backed by commercial mortgages rather than residential mortgages. CMBS use structures similar to other forms of ABS. 64 bn Collateralised loan obligations (CLOs) CLOs are pools of corporate loans, refinanced in a securitised structure. These can either be static pools from a bank balance sheet or a managed product run by a specialist loan manager. 83 bn Total 1.1 tn 2 Source: Securities Industry and Financial Market Association as of Q1 2016, TwentyFour Asset Management. Note definition of each market segment is not precise and differs between market data providers. 3 TwentyFour Asset Management as of July 2016. See Figure 7 for further details. 5
Figure 3: Example ABS capital structure RMBS: A Sample Structure Interest & Principal Total Notes Issued 720m AAA Notes 1bn property pool 720m mortgage pool Mortgages AA Notes A Notes BBB Notes BB Notes Reserve Fund Excess interest Home owner s equity: absorbs first loss Further losses 1. HOMEOWNER EQUITY The first loss is absorbed by the home owner s equity in the property. In our example above, this amounts to 280 million or 28 percent. In other words, before ABS bondholders suffer any losses, three things would need to happen: on average house prices would have to fall more than 28 percent, homeowners would need to default and the other protections mentioned below would need to be exhausted. 2. EXCESS INTEREST This is the interest in excess of what is needed to pay the coupons on the ABS, represented by the white box in the diagram above. It normally goes to the issuer of the ABS. However, if there is a loss on the sale of a defaulted property, this excess interest from the rest of the performing mortgage pool covers the loss. Therefore, it provides additional protection for the bondholder and helps to align the interest of the bondholder and issuer. 3. RESERVE FUND This is a cash account set up by the bond issuer. It acts as a further cushion for protection and can be drawn down to offset losses. Once these three layers of protection are exhausted, losses are allocated to the most junior tranches. In the diagram above, the first tranche is rated double-b. The tranche has to be written down to zero before losses are recorded in the next tranche, rated triple-b. This affords additional protection for ABS in more senior tranches, such as those rated triple-a. Collectively these three layers of protection plus tranching provide credit enhancement. ABS risks also reduce with time. Firstly, as the loan is paid down the outstanding principal is reduced. Secondly, rising asset prices improve the collateral s value. The same is also true for the ABS deals themselves. As the underlying asset pool is amortised (through prepayment, maturity or even the gradual amortisation through scheduled monthly repayments), the relative size of the protection layers generally increases: junior tranches, home owner s equity and the reserve fund. LET S REITERATE THE BENEFITS OF EUROPEAN ABS: Bankruptcy remote: The assets sit within a segregated legal entity the SPV protecting them from outside events such as bankruptcy of the sponsor. Direct recourse: They are backed by specific asset or loan pools, where the coupons and principal are generated by the underlying assets. Built-in loss protection: They are structured into multiple layers of risk once credit enhancement is exhausted, junior tranches take losses before more senior ones. Highly granular: They are geographically diverse, containing thousands of real economy assets such as residential mortgages, auto loans, credit cards or SME loans. Highly transparent: They offer detailed and frequent reporting, thereby enabling investors to conduct quantitative and qualitative research. Alignment of interest: The issuers are required by regulatory authorities to retain skin in the game. HOW EUROPEAN ABS DIFFER FROM US ABS Although they share the same acronym, European ABS are not the same as their US counterparts. European ABS have distinct differences making them more investor friendly, with a much better track record. These differences include: 1. Higher lending standards The lending standards for European residential mortgage backed securities are generally higher than their US counterparts as borrowers are required to hold significant equity in the property and demonstrate proof of income before loans are granted. Unlike in the US, there is no true sub-prime market in Europe. In the US, the RMBS market predominately focuses on sub-prime because the prime market largely conforms to agency lending standard i.e. those set by Fannie Mae and Freddie Mac. 6
2. Alignment of Interest In the majority of deals in the European ABS market, the first loss piece is retained by the issuer of the ABS. Historically, in most US RMBS all the risk was fully transferred from issuer to the bondholder, encouraging the issuer to focus on increasing volume to earn origination fees rather than maintaining quality. 3. Recourse The US mortgage market is a non-recourse market, so the property is the only way of mitigating a loss in a default scenario. This means that borrowers in default can hand the keys for a property back to the bank with no threat of further action to enforce repayment. In European mortgage markets, the lender can continue to pursue borrowers for recovery after default for a multi-year period. This has a material impact on the post-default life of the borrower, creating a more powerful obligation to pay. This has led to much lower default rates in comparison. ADVANTAGES OVER SENIOR SECURED LOANS Senior secured loans are loans made to corporates, typically of sub-investment grade, which will be originated by banks but may be syndicated to investors. These loans are secured on the assets of the corporate. CLOs are then bonds which are backed by senior secured loans, which gives the CLOs attractive ABS characteristics. Here we compare senior secured loans to ABS because both fit into clients alternative allocations and can fulfil similar client needs. However, ABS offer significant advantages over the loan market: Larger: The European ABS market at about 1.4 trillion is far larger and more liquid than the loan market, which is only around 100 bn 5, making it less suitable for institutional investment. More choice: Loan issuers are typically sub-investment grade, whereas ABS offers a wide range of credit ratings from triple-a to unrated. Greater diversification: ABS are structured with loss-absorbing characteristics and pool risks across a diverse set of many loans, meaning that large-scale defaults and reductions in property value are needed to cause losses to investors. In contrast, senior loans depend on individual companies ability to make repayments, meaning that one default can result in losses for investors. Diverse exposures: The loan market contains purely corporate exposure, whereas ABS enables exposure to corporate and consumer lending. Better risk-return: The European ABS market has a lower default and loss rate than the European loan market, plus European ABS offers a higher yield on a comparable rating basis. Rather than making a direct investment in a senior loan, the loan market can be accessed via the CLO market with better yields and typically more defensive characteristics. Figure 4: Differences between European and US RMBS Europe and US are Different Majority of RMBS Originated by Banks Generally Higher Lending Criteria Historical Use of Affordability tests Typically Recourse Lending Personal Stigma of Insolvency Banks Generally Service Securitised Assets Banks Typically Retain First Loss Cumulative expected lifetime loss rate 4 0.3% 8.1% 4 RMBS Losses 2000-2014, Fitch Global, 7th February 2015 5 Credit Suisse Institutional Western European Leveraged Loan Index, June 2016. 7
ADVANTAGES OF INCLUDING EUROPEAN ABS IN A PORTFOLIO European ABS can add diversity to a fixed income portfolio, as well as providing additional yield. ABS is probably the most flexible part of the fixed income universe, offering the ability to invest across the full spectrum of ratings from triple-a to single-b and even unrated. By selecting bonds carefully, a highly liquid profile can be created, or alternatively a yield premium can be earned for less liquid positions. With current yields ranging from EURIBOR plus 25bps (effectively a zero yield) to the low double digit (11 percent yield in May 2016), a risk-return profile, with a specific liquidity focus and sectoral and geographical limits can be created for a wide range of purposes and types of investor. TwentyFour Asset Management currently runs mandates that range from high quality investment-grade, to mixed investmentgrade and sub-investment grade funds that are seeking to maximise income and capital growth. Therefore, the strategies we manage can be compared with cash, sovereign bonds, senior secured loans, corporate bonds and high yield bonds, but typically offer a better risk-return profile. Broadly speaking, our ABS products can be compared with the following traditional asset classes, when considering the return offered rather than other fundamental characteristics: An enhanced cash strategy Cash and money market investments An investment grade strategy Corporate bonds A higher yield strategy Strategic bonds, high yield bonds and hedge funds UNDERSTANDING THE RISKS It is possible to classify risk on a basic level into credit risk (as denoted by rating), interest rate risk (duration) and spread volatility (credit spread duration and historic volatility). Credit risk in ABS varies according to the rating of the instrument and the rating is driven by a number of fundamental characteristics of the security e.g. the quality of the collateral, the defensiveness of the structure and the geography. Ratings are independently determined by agencies such as Standard and Poor s, Fitch and Moody s, based on a detailed assessment of these factors. In Europe these ratings have proved reliable. Even during periods of market stress such as the 2008 financial crisis, very low default rates were observed. The key difference to other types of fixed income investment is that interest rate risk is minimal as the vast majority of European ABS are floating rate. There are no indices for European ABS, therefore it is difficult to track volatility for segments of the market. Instead, we can compare the volatilities and risk characteristics of the different TwentyFour strategies in figure 5. All of TwentyFour s strategies are diversified across the different types of ABS with the sector analysis designed to provide a riskreturn-liquidity profile in line with the fund s stated aims. In general the enhanced cash strategies contains higher rated instruments, while the higher yield strategy focused on less liquid instruments. Figure 6 shows that TwentyFour s ABS portfolios offer higher yields than traditional fixed income investments, even though they invest in higher-rated assets. Figure 5: Risk characteristics of European ABS Strategy type Weighted average Historical default rate 3-year volatility 8 Gross yield 9 Liquidity Rating Interest rate duration 6 Credit EUR GBP EUR GBP duration 7 TwentyFour Investment Grade Strategy TwentyFour Higher Yield Strategy AA- Floating rate, so close to zero 3.5yrs None since inception 2.41% 2.41% 2.24% 2.87% High BB 4.1yrs 5.45% 5.36% 7.20% 7.83% Medium Source: TwentyFour Asset Management. 30 June 2017. 6 Interest rate duration: Sensitivity of returns to changes in interest rate 7 Credit duration: Sensitivity of returns to changes in credit spreads 8 3 year volatility numbers calculated using monthly returns annualised. While volatility numbers are stated in each strategy s base currency, these are representative of other currency volatility numbers once the strategy is hedged into the appropriate currency 9 Gross yield calculated as the return a bond earns on the price at which it was purchased if held to maturity. The stated gross yield is the yield of the representative portfolio in the strategy, and the EUR and GBP gross yields are calculated by adjusting for the estimated monthly cost of hedging the portfolio over 1 year, by calculating the difference between the current two currency 1 month base rates. 8
Figure 6: Credit spreads of ABS strategies Credit Spreads 8% 7% 6% Twenty Four High Yield ABS Strategy 5% 4% 3% 2% Twenty Four Investment Grade ABS Strategy Pan-European High Yield Index US Corporate High Yield Index 1% Sterling Aggregate Corporate Index 0% AAA AA A BBB BB B Credit Rating TwentyFour Floating Rate Strategies - MTM Credit Spread Bloomberg Barclays Fixed Rate Credit Indices - Average OAS MTM Mark-to-Market. Past performance is no indication of current or future performance. Source: TwentyFour, Bloomberg. 30.06.2017 MARKET OUTLOOK European ABS offer attractive yields, improving fundamentals, limited supply, and potential for capital gains through tightening spreads: 1. Attractive yields: Figure 7 below shows that for any given rating, ABS offers a higher yield than traditional fixed income. Note that Consumer Receivables is not included below as data is sparse and focused on the higher ratings buckets. As an example, triple-a German Auto loans currently offer yields of around 15-20bps over EURIBOR. Figure 7: ABS and corporate spreads by rating and asset class Credit spread (bps) 800 700 600 500 400 300 200 100 0 Prime RMBS Buy To Let RMBS Near Prime RMBS CMBS CLOs Euro Corps Corps $ Corps AAA AA A BBB BB B 45 100 150 200 340 65 145 180 220 60 135 180 230 105 140 190 250 80 140 200 300 530 735 22 35 72 113 222 394 27 56 104 153 278 464 61 58 84 139 245 401 Source: TwentyFour Asset Management, Barclays 06.07.2017 9
Figure 8: Unemployment rates in Europe, % 30 25 20 15 10 5 0 Jan 10 Mar 10 May10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May13 Jul 13 Sep 13 Nov 13 Jan 14 Mar 14 May14 Jul 14 Sep 14 Nov 14 Jan 15 Mar 15 May15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May16 Jul 16 Sep 16 Nov 16 Jan 17 Mar 17 May17 UK Netherlands Portugal Italy Spain Source: Bloomberg, 06.07.2017 Figure 9: House Price Index, Year on Year change, % 15 1.2 10 1 5 0.8 0 0.6-5 0.4-10 0.2-15 Jan 10 Mar 10 May10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May13 Jul 13 Sep 13 Nov 13 Jan 14 Mar 14 May14 Jul 14 Sep 14 Nov 14 Jan 15 Mar 15 May15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May16 Jul 16 Sep 16 Nov 16 Jan 17 Mar 17 May17 0 UK Netherlands Portugal Italy Spain Source: Bloomberg, 06.07.2017 2. Improving fundamentals: The credit risk of European ABS has also been improving thanks to falling unemployment (Figure 8) and a recovering housing market (Figure 9) in the markets with greatest RMBS issuance volumes. ABS has performed consistently well through a number of market cycles including the recent financial crisis. During the depths of the financial crisis, European ABS outperformed other asset classes from a default and a loss point of view. As such, Brexit is not expected to present significant challenges to fundamental performance. 3. Limited supply: Traditional ABS issuers have always had a number of sources of funding ranging from retail client deposits to equity issuance. However, with the readily available supply of cheap funding from central banks, new ABS issuance has dropped materially. While there have been the odd periods of oversupply due to market technicals, this dynamic of low supply will support price performance due to the scarcity of product. 4. Potential for capital gains: The yield differential between ABS spreads and those available in other fixed income markets remains attractive and issuance volumes have been low in 2017, setting up a strong technical outlook for spreads to tighten and reward holders with attractive capital gains. 10
CONCLUSION ABS are mostly floating rate securities, which have minimal interest rate risk. They provide higher yields than traditional fixed income instruments for a given rating. They are structured to provide credit enhancement and attractive defensive risk characteristics, partly through pooling of assets and tranching of bonds, and partly through other credit enhancement techniques. Highly transparent reporting means that experienced managers are able to gain exposure to pools of specific assets and find value within this under-researched segment. European ABS are fundamentally different to US ABS, with higher lending standards, a greater alignment of interests with bondholders and full recourse. Historically, European ABS loss rates are significantly lower than US loss rates. ABS also offer significant advantages over senior secured loans, with CLOs enabling higher yields with lower risks than similar senior secured loans. Now is an opportune time to invest in ABS, given attractive yields, improving fundamentals, limited supply and potential for capital gains if spreads tighten. 11
This document is intended for Professional clients only and should not be relied upon by anyone else. The information contained in this document is for information purposes only and should not be relied upon as the sole basis for making any decision relating to making an investment. Nothing in this document constitutes a solicitation, or offer, or recommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever and the information has been prepared without taking into account your investment objectives, financial situation or particular needs. The above data and graphs are provided for illustrative purposes only; the information contained in this document may change, be amended or deleted without notice at any time. Data has been adjusted in its preparation and has been based upon prevailing market rates as at the date given. Past performance is not a reliable indicator of current or future performance. The value of invested monies can increase or decrease and there is no guarantee that all or part of your invested capital can be returned. WHILST TWENTYFOUR ASSET MANAGEMENT LLP BELIEVES THAT THE INFORMATION IS CORRECT AT THE DATE OF ISSUE, NO WARRANTY OR REPRESENTATION IS GIVEN TO THIS EFFECT AND NO RESPONSIBILITY CAN BE ACCEPTED BY TWENTYFOUR ASSET MANAGEMENT LLP OR THE FUND TO ANY INTERMEDIARIES OR END USERS FOR ANY ACTION TAKEN ON THE BASIS OF THE INFORMATION. Although Vontobel Asset Management AG ( Vontobel ) believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this document. Except as permitted under applicable copyright laws, none of this information may be reproduced, adapted, uploaded to a third party, linked to, framed. The information in this document is not suitable for use in any jurisdiction where such activity is prohibited. Neither this document nor any copy of it may be distributed in any jurisdiction where its distribution may be restricted by law. Persons who receive this document should make themselves aware of and adhere to any such restrictions. In particular this document must not be distributed or handed over to US persons and must not be distributed in the USA. Potential investors should seek professional guidance before deciding on whether to make an investment. TwentyFour Asset Management LLP is registered in England No. OC335015, and is authorised and regulated in the UK by the Financial Conduct Authority, FRN No. 481888. Registered Office: 11 Monument Street, London, EC3R 8AF. Copyright TwentyFour Asset Management LLP, 2017 (all rights reserved). This document is confidential, and no part of it may be reproduced, distributed or transmitted without the prior written permission of TwentyFour. twentyfouram.com 24116D 04/09/17 8th Floor The Monument Building 11 Monument Street London EC3R 8AF T +44 (0)20 7015 8900 F +44 (0)20 7015 8901 E sales@twentyfouram.com