Exploiting the opportunities within asset-backed markets | Insight Investment

Hi, my name's Andy Burgess and today I am gonna be talking to you about the potential for you to exploit some of the opportunities within asset backed markets. Now given the recent focus in corporate bond markets and the level of returns available, we are going to look at some of the options for you to consider in this quite tight spread environment. Now we're going to cover three things today. What are asset-backed securities and how do they work? A brief refresher for you taking a look at whether they're attractive or not and trying to compare them with other credit instruments. And then lastly, understanding how investors might use these type of investments as part of their broader mandates. 

So first of all, what are asset-backed securities or ABS? Now it's an area in the market that's rife with acronyms and we're going to start with understanding ABS. This stands for a security that's backed by an asset. Now that could be series of cash flows or a loan against and secured against a particular set of assets. Now that's important because they're bankruptcy remote. They're in a separate legal entity from the originator of the underlying loans. Now these loans form part of what's called the collateral pool, and that's where your risk as an investor is not to the underlying originator. So they form quite an interesting diversification against other assets, whether they be equities or corporate bonds, because your credit risk is fundamentally different. 

They also pay a floating rate or a return over and above a cash rate. Think of the short term interest rates such as the Bank of England policy rate, and that means they're not vulnerable or sensitive to longer term moves in government bond yields and long-term inflation and interest rate expectations, so they're less volatile. 

They're also typically shorter dated than many other credit assets, typically about half that of corporate bonds. That means they're less volatile. Now that can be good and bad when we're in a very attractive environment, very wide spreads that you expect to narrow that can be bad. You benefit less from severe or significant tightening and credit spreads. But actually an environment like today where credit spreads are quite tight, that means they're less volatile but less vulnerable to sell offs too. 

The other characteristic which is attractive is that they're offer a wider range of credit quality options. You can invest materially in AAA rated asset-backed securities, an opportunity set that's much more limited in corporate bond markets. And lastly, and probably most important of all is they offer what's called complexity premium and additional return, Not for taking more credit risk, but from the complexity of the analysis required to understand your risks appropriately. 

Now, I mentioned that these are asset-backed securities. So what are the sorts of asset that backs these bonds? Well, we group them into three main areas, residential and consumer type assets. So think of a pool of residential mortgages, car loans, credit cards, or even consumer loans. Typically pools of thousands of underlying borrowers within a single country. 

The second type would be what we call commercial. Now these are typically a loan secured against a commercial property or series of commercial properties, whether they be retail in the office space or even logistics and warehouses. Data center deals also fall into this category. The third is corporate risk. Now this is a pool of typically a hundred to 150 loans to underlying corporates. The corporates themselves tend to be lower quality, high yield companies, but actually the way the structures are set up means you can benefit from protection within the structure itself, but three different types of asset that come look quite different to each other. 

Now, how do these deals get structured? Well, we're gonna take the example of a residential mortgage backed security just to start us off. A bank will originate a pool of mortgages. They'll decide who to lend money to and go through the normal checks to understand the credit risk of those borrowers. Now, once they've originated those loans agreed to pay the money, they will set up what's called a special purpose vehicle, a separate legal entity that's off their balance sheet. This special purpose vehicle or SPV is bankruptcy remote from the bank. It issues a series of asset-backed securities and buys the mortgages off the bank's balance sheet. 

Its only assets are the fundamental underlying mortgages. It appoints a servicer to collect the payments from the underlying borrowers that servicer typically the originating bank. And many of us are in asset-backed securities and we simply don't know. It's completely invisible to the underlying borrowers. 

Now that servicer will then collect the mortgage payments, partly interest, partly principle, and the proceeds from that will use to pay down the asset-backed securities and to pay the interest rate or the coupon on those bonds. Now, asset-backed securities we'll see in a minute, are structured in different tranches, senior tranches, all the way through to more junior tranches or subordinated tranches. All tranches receive the interest payments, but importantly in most deals, the more senior bonds get their money back first, their principle paid back first and that money and cash flows are prioritized towards the more senior higher quality bonds. First, lower quality, more junior bonds second. 

Now let's carry on that analysis of a residential mortgage backed security. If I buy an asset-backed deal that's backed by residential mortgages and everybody that's borrowed money pays back their mortgage and interest rate on time, well then I get my money back and everyone's happy. But what am my protection as an investor in this asset class if things start to go wrong? 

Well, the first level of protection that we have is that the borrower pool is very diversified. 

We have a range of borrowers typically in a country all employed in different sectors of the economy, and that diversification really helps. The second level of protection is that mortgage borrowers don't borrow all the value of the property. They have to put their own deposit down or put their own equity against the deal. A typical loan to value for a UK residential mortgage backed security is somewhere between 60% and 70%, effectively a 30% to 40% equity state. Now, if a borrower defaults in their mortgage, the bank ultimately can repossess that house, sell it, and use the proceeds to pay off the mortgage. So your first level of actual protection is the equity from the borrower in the deal. 

The next point is, well, what happens if the house is worth less than the mortgage? Well, in most jurisdictions, certainly in the UK and Europe and Australia, we have recourse to the underlying borrowers even if they're a negative equity. And that means people keep paying their mortgage even if the house is worth less than the mortgage itself. 

The next level of protection excess spread is the difference between the mortgage rate, the borrowers pay, and the average interest rate paid to investors. That positive difference or excess spread between those two interest rates goes into the structure and is trapped there to help meet defaults within the underlying borrower pools. 

Next, there is a reserve fund or a cash account. Within the structure, this is typically about 3% of the deal. This faces losses first and is topped up by the excess spread from the people in the pool that are continuing to pay their mortgage. The next level of protection you have as investors is to what's called the equity tra, or typically the originator's money that is within the structure. This can be up to 7% or even more in some cases, and again, takes losses first before you as bond holders. So in other words, before we get anywhere near to asset-backed securities, a borrow a pool can absorb essentially everybody to defaulting. 

So these three 5,000 borrowers to defaulting and eroding all of the borrower equity, which could be 30% to 40% and the reserve fund of 3% and the equity tranche of 7%. So for a deal where the average loan to value is 60%, you can essentially absorb everybody defaulting on their mortgage and house prices falling up to 50% before bond holders actually face losses. Now from then on, the amount of protection you get over and above that depends on which tranche or where you are on the structure. On the right hand side, the higher quality you are, the more protection you have, but the lower return you experience. Similarly, the lower quality notes you invest in, the higher return you get, but the more risk. But all ABS investors benefit from that excess spread, the borrower diversification and the reserve and equity tructure. 

Now, when we are looking at borrower quality and loan quality and trying to assess whether an asset back security is attractive, you need to follow a number of different areas. Firstly, what is the quality of the underwriting process from the originating bank? How good are they at determining the credit risk of the underlying borrowers? Who is borrowing the money and how strong a borrower are they? 

The next level you need to consider is what is the value of the asset that you are secured against? How volatile is that asset and how does that compare to the value of the mortgage? That's the second line of your defense. Don't forget, the third step is the bond structure. How many people are below you in the capital structure? How much extra protection does that give you over and above the borrower quality and diversification and the value of the asset? How do cash flows change under different circumstances? You have triggers in deals such as if the loan to value goes above a certain threshold, then cash flows can be diverted to more senior bond holders giving you even extra protection. 

You need to stress test each of the deals to understand what you can absorb in terms of borrowers defaulting changes in underlying asset values, unemployment inflation, interest in the likes to really understand what happens if things start to go wrong. And then lastly, you need to understand where there's value once you've correctly assessed all of the different credit risks. And this can be across those different areas of the market, but also different jurisdictions and different levels of credit risk. 

Now, taking a real life example, and here's a deal by an Australian lender called pepper that issued a residential mortgage backed security in the UK secured against the UK mortgages. Now they're a specialist mortgage lender. They've got a very robust underwriting process and have a very strong track record. When we look at their lending activity over the last 10 to 20 years. Now this deal itself has nearly 2000 underlying mortgages that are on average about £165,000 in size with a loan to value of 65%. So a diversified range of borrowers not with with normal size mortgages. And you've got 35% percent protection 

from the equity value against each house. On average, there is an excess spread of 2% so that everybody pays their mortgage is generating 2% of cashflow to help protect you through time as well. Now all of those levels of protection are available to all the different tranches in this deal. The table on the top right hand side though, you can see the range of investments backed by that single collateral pool and the options for investors. Now, the most senior tranche, the Class A notes AAA rated the highest credit quality rating available. It's the largest component of the structure. You have all those protections from the collateral pool and an extra 12% of what's called credit enhancement. So that's the reserve fund, the equity tranche and people below you in the capital structure to absorb losses over and above that protection from the borrower equity of 35%, but it does only pay 80 basis points over short-term cash rates. 

As you go further down the class notes into the class D and E notes, which are BBB rated, it's so similar to corporate bonds, you'll notice they're smaller tranches, which will be less liquid. You get less protection from the credit enhancement. You still get all the borrower protections, but you get much less protection from the additional protection of the structure. But the return also significantly increases to nearly 2.5% over and above short-term cash rates. 

And when we are looking at asset-backed securities overall and we understand now a little bit more about how they work, what drives their value across the different opportunity set? Well, the first one and quite obvious really, is that the more risk you take, the higher return you'll ask for. 

The second is that the more complex the instrument, the more complex the analysis required, the more esoteric it is. Also that complexity premium we've spoken about also increases. The longer data you are exposures are the longer you are taking that credit risk, the more return you'll demand. And similarly, the lower liquidity, the more esoterical junior notes you are that are smaller in size, the higher the demand, the higher the return you'll demand to. 

Now, when we look across the ABS market and we compare spreads in different parts of the ABS market to corporates largely of A or BBB quality and have a similar sort of maturity profile, we can see that all parts of the ABS market generally offer a pickup over corporate bonds, but it does vary. Now, I'm not going to go through each of these different types of ABS in turn, but just really to note that the more credit risks are the lower quality you go such as the BBB rated deals, the higher you'll return, the more esoteric it is, such as aircraft securitizations, the higher the return. And if you go further into illiquid credits, so private deals such as asset backed funding or forward flow whole loan deals, the return picks up even further. And that's because you are sacrificing liquidity too, not just benefiting from the complexity premium. 

And when we look at that over time and understand how this complexity premium has varied, unfortunately we can't show you a slide that demonstrates this using market indices. You'd benefit from a return perspective from the complexity premium, but it does make market wide analysis much harder. So what we've done here is just show a range of our different port funds, which do offer returns based on different credit tranches or ranges within the credit spectrum across the ABS universe. Now, the dark green line near the bottom represents the additional spread for investing in investment grade relatively short dated, so similar to ABS 

Sterling corporate bonds. Now you can see that you can go significantly up in credit quality to AAA to the highest credit risk available, highest credit quality available, and yet only sacrifice a very modest amount of return. Similarly, you can actually benefit from high quality investments in the high grade ABS strategy, which is broadly similar to AAA - AA rated instrument, and actually pick up spread. That spread pickup increases even further when you look at the returns available within sort of double a single a credit spectrum. And then lastly, if you benefit from both the complexity, premium and illiquidity premium, well that's the dark line in dark blue represented by our secured finance vehicle. 

Now if you are comparing like for like in terms of credit quality, that's the shad area, that's a sort of level of additional return you can get by investing in BBB rated Asset backed securities, similar credit risk to corporate bonds. And you can see there's a material pickup in returns for investors. 

Now the asset class itself, um, we understand a little bit more now from a credit perspective how they work, but there's some technical factors to think about too. 

Before the GFC asset-backed securities were a core component for many insurers. Now that changed for the introduction of different regulations including solvency two and the gap between the attractiveness of the asset classroom and economic perspective and from a capital adjusted perspective for insurers essentially made the asset backed market almost uninvestible for a big part of the investor base. 

Now that's changed modestly through time, but is set to make a step change from the end of January next year. The rules are changing. The capital treatment of asset-backed securities for investors that are insurance companies is becoming much more attractive. This shows the current level of capital charge for a five year senior, what's called non STS position, a non STS classified bond. And that stands for simple, transparent and standardized. It is a big part of the ABS market under current regime and the future state from the end of January, 2027. And you can see a massive improvement, a reduction in the capital charges for these type of instruments. And that's going to bring in our view a significant new investor base back to the market. 

Now that is likely to be supportive for spreads. We do think to a great extent it's going to be mitigated by higher degrees of issuance, but it's still net a big positive. 

That isn't a technical demand perspective that's in place for corporates. In our mind, the spread level within ABS is probably much more two-way than it might be within corporate bond markets. 

Now when investors are looking at this asset class, how can they exploit this opportunity? And it's always a balance of three factors, the return available, the amount of credit risk that that return requires, and the liquidity of the instrument and how that matches your liquidity needs. Now unfortunately, many um, investment opportunities in this market follow a one size fits all approach. Essentially assuming that whether you are using this asset class for your collateral purposes or as a corporate treasurer or indeed as an insurance company, that you all have the same return risk and liquidity profile. And that's simply isn't true. 

And unfortunately, managers then will what's called barbell. They will take some lower quality instruments to try to increase the return, but also some very high quality liquid instruments to meet any liquidity needs. And that means a suboptimal investment construct. 

Far better we think to provide investors with a range of opportunities where you can set the appropriate balance across three factors. If liquidity is most important, well then why not invest in a strategy that is designed to achieve that. If however, return is much more a driving force, well then maybe you are willing to sacrifice a little bit of liquidity to achieve and to optimize that. 

Now again, I mentioned there are very few benchmarks or mark market based indices that we can use to demonstrate this. So we're showing again, our range of strategies that can give you a flavor for the return profile, the credit risk that you take, and the liquidity terms of all of these type of instruments and to group them to show what type of asset classes are used by what sort of investors. 

Now, the higher quality, more liquid instruments and vehicles, you can see at the top they offer us lower return than others. It's still very attractive versus cash though. 

And for a higher quality instrument than corporate debt of those types of vehicles, liquid ABS, high grade and global ABS are typically used either by cash plus type investors. So think corporate treasurers looking to enhance returns without taking undue credit risk as part of collateral waterfalls within defined benefit pension schemes or indeed as a diversifying asset class against other investments as part of a broader portfolio. As you move further down the credit risk spectrum, you are focusing more upon return generation or indeed income generation in particular the secured finance type of vehicles where you're happy to sacrifice liquidity because you are using it to generate a income profile. Over time, those types of strategies take more risk but deliver significantly higher levels of spread, therefore return potential to investors. 

Now, when we are looking to compare the asset class against corporates and we've shown that you can pick up additional return and indeed spread within the asset class, benefiting from that complexity premium, we try here and show what happens if you're comparing more like for like in credit risk. Now this is our enhanced ABS strategy as I mentioned. because of the lack of market data we're showing this as a guide. You can see that second bullet point down on the left, the yield, the yield on the asset class, it's about 6.5% versus at the time of this recording about 5% for investment grade corporate bonds. It is less volatile because it has no interest rate risk. 

It is a floating rate asset and it's shorter dated typically about a half to two thirds of the maturity profile of investment grade corporate bonds. 

But it's the same level of credit risk broadly. So that extra return is coming from the complexity of the asset class rather than more credit risk. It is well diversified whether you look at the geography of the underlying markets or the sectors that we're taking that credit risk within residential assets, commercial mortgage backed assets or corporate backed assets, and that's the acronym CLO or collateralized loan obligation. Again, each of the underlying deals within a portfolio themselves would be diversified and backed by potentially up to thousands of underlying borrowers. It's a different credit risk in the main as well from corporates here within residential for example, your exposure, as I mentioned, is to people paying about that mortgage not to corporate earnings. 

You also have the flexibility to invest across the credit risk spectrum within this part of the market. You're getting that higher yield, but within an average investment grade rating, which gives a bit of flexibility to invest into high yield opportunities when they're attractive to do so. 

Now, to wrap all of that up, what have we covered today? Well, firstly that the complexity premium asset markets can be attractive to investors. They can be more resilient. They're shorter dated, higher quality potential than many corporates. And that provides you with a degree of resilience and protection against selloffs needed credit spreads or indeed government bond markets. 

Now, the market outlook is robust and the relatively benign economic outlook certainly supports that. But the asset class also benefits from supportive regulatory changes that are happening over the next 12 months. 

The asset class gives you much more flexibility to precisely fine tune how much credit risk you want to take, the returns you are aiming to target, but also the liquidity profile of your investments. And that's why we think more and more investors are starting to think about the ABS market to either generate your return that you need to provide a broader level of diversification or indeed just to support broader solutions such as part of a collateral waterfall. 

So thank you for your time today. If you have any questions or would like to explore any of the themes we've covered today, please contact your insight representative. And lastly, thank you for me for your time.