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Market View

Lord Abbett investment leaders discuss the current environment for ABS—and how aspects of these securities designed to protect investors might work during an economic downturn.

 

In Brief

  • Investors may have questions about asset-backed securities during this period of market volatility.
  • Lord Abbett investment professionals discuss the potential investor protections that are part of the designof some of these consumer-focused securities, along with how ABS have fared in light of the economic disruption caused by Covid-19.
  • Historically speaking, defaults on ABS have been rare in the past few decades, even during the 2008-09 financial crisis.
  • Further, measures introduced by the U.S. Federal Reserve (Fed) and Congress designed to provide aid to the U.S. consumer during an economic downturn may lend support to the ABS market.

 

In the first of a two-part series looking at structured financial products amid the current market volatility, last week’s Market View focused on commercial mortgage-backed securities. This week, we will turn to CMBS’ more consumer-focused cousin, asset-backed securities (ABS), with insights derived from a recent webinar featuring Lord Abbett Managing Director & Portfolio Manager Adam Castle, Investment Strategist Andrew Fox, and Director of Product Strategy Stephen Hillebrecht. (Register to view a replay of the webinar.)

What Are ABS?
Consumer-linked ABS are financial securities collateralized by a broad spectrum of consumer receivables such as credit card receivables, auto loans, and student loans. The ABS market consists of a half-dozen major sectors and several dozen subsectors that include aircraft leasing, credit card debt, cell tower leases, and even timeshare loans, among others.

As Castle noted in a previous commentary, ABS structures are typically debt holder-friendly in that they restrict cash flow to equity, while forcing the transaction structure to de-leverage over time or, at the very least, maintain levels of leverage. There are numerous components to the overall structure of an asset-backed security. The structural protections that may be embedded with an ABS for the benefit of investors are collectively considered “credit enhancements.” Total credit enhancement is a key factor in assessing the creditworthiness of an ABS in the context of the risk profile of the trust’s underlying assets.

“The original lender would have to sustain a loss before investors in an ABS deal would sustain a loss,” Castle notes. He offers an example: “Typically for an ABS backed by prime auto loans, there would need to be around a 5%-10% default rate that would have to take place in order for the AAA-rated tranche to sustain a principal loss. He notes that as of early March 2020, before the full impact of the Covid-19 crisis, default rates on prime auto ABS were “very low,” based on data from S&P Global. In the 2008-09 financial crisis, defaults went from roughly 0.5% to 2%. “Around 15 to 20 times that default level would be needed before a ‘AAA’-rated asset-backed auto deal in one of Lord Abbett’s portfolios could potentially be negatively affected,” Castle says.

Castle says Lord Abbett’s investment team has emphasized “more seasoned, mature ABS deals that were originated one to three years ago.” In looking at coverage multiples on the ‘AAA’-rated segments of the ABS deals that Lord Abbett owns, “they can potentially withstand typically 30 to 50 times more losses than are currently being experienced.”

Addressing concerns about the current economy and the prospect of sharply reduced consumer spending, Hillebrecht notes that “the consumer has gone through other periods of difficulty in the past.” He cited the historical default record for ABS (see Figure 1). “If you look at the default rate on ‘AAA’-rated asset-backed securities going back to 1986, the rate has been zero, and on ‘AA’-rated ABS, it's been zero in every year except one blip in 2002.”

 

Figure 1. Historically, ABS Defaults Have Been Extremely Rare
Default rates of asset- backed securities by credit-rating tier, 1986-2018

Source: S&P Global Ratings. Data based on a historical study of defaults by S&P Global; most recent data available.  Subject to change based on changes in the market.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

ABS Is a Consumer-Focused Asset Class
When you think about ABS, traditionally, you think about exposure to the U.S. consumer and households … consumer balance sheets are a significant proportion of the U.S. economy,” says Castle. Before the Covid-19 impact, those balance sheets had been strengthening, with lower levels of leverage and a higher savings rate.

“Historically, exposure to consumer ABS has provided a very valuable diversification component to a short duration strategy,” he added. Typical consumer loan products, like auto loans, are short duration in nature, according to Castle. Balances on credit cards, a form of revolving debt, are paid off monthly by a significant number of consumers, he says. “So not only are they short duration, but they give us access to a very significant component of the U. S. economy, in line with our desire to position ourselves for more domestic strength relative to the global economy, and for lower leverage relative to U.S.-based multinational corporations.”

Of course, Castle notes, the Covid-19 pandemic affects all facets of the global economy, including the U.S. consumer's ability to make money to service household debt. But as Fox pointed out in a commentary published on April 1, recent actions by the U.S. Federal Reserve (Fed) and U.S. Congress are aimed at providing significant relief to the U.S. consumer—and could potentially support the ABS market as a consequence.

Current Environment
Since the worst of the volatility in the third week of March, ABS spreads have narrowed somewhat, “but we are certainly not back to where we were,” says Fox. “Certainly the things that the Fed has done—in a sense, pulling out some of these old tools that they created for the 2008-09 financial  crisis—have been very helpful this time around.”

Based on data from Bloomberg, “the recovery in spreads from today [April 7] relative to March 23 has been about 50%,” Castle added. “That's a significant recovery—though spreads are still pretty wide—and what that really reflects are the attempts to address the liquidity problems facing the market.” After the Fed’s efforts to bolster liquidity, “what we're really left with is an elevated risk premium that exists across asset classes considering the degree of volatility and the fundamental uncertainty that pervades all markets.”

We see that the market isn't being efficient right now, and that there are plenty of opportunities for us to generate alpha in this environment. He believes the potential exists for active managers to realize a stronger rebound than the benchmark short credit indexes experienced following the volatility in 2008-09 (see Figure 2).

 

Figure 2. ABS Sector Was Part of a Strong Recovery in Structured Products Following the Global Financial Crisis
Total return for the indicated periods

Source: Bloomberg Barclays Index Data. Short-term corporates=Bloomberg Barclays 1-3 Year U.S. Corporate Bond Index. CMBS (commercial mortgage-backed securities)=Bloomberg Barclays Non-Agency CMBS Index. Short-term CMBS=Bloomberg Barclays 1-3.5 Year Non-Agency CMBS Index. ABS (asset-backed securities)=Bloomberg Barclays ABS Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

In today’s market, says Castle, “we believe short credit still makes a lot of sense.”

ABS as Part of a Flexible, Multi-Sector Approach
Hillebrecht noted that given Lord Abbett’s flexible multi-sector approach to short credit, “ABS is just one asset class that we can invest in.” He believes that such a strategic focus can potentially enable asset managers to “find pockets of liquidity to take advantage of opportunities during market dislocations.” Fox concurred. “That’s one of the nice things about being multi-sector—and a lot of our strategies are structured that way.”

Fox summarized Lord Abbett’s approach: “It's not just about going out there and finding the absolute cheapest thing you can possibly find…it’s about the ability to rotate among sectors, careful credit analysis, and a rigorous approach to security valuation.”

“The idea here,” he concluded, “is that our investment teams have a lot of levers to pull.”

 

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