Since being introduced to the marketplace in the mid-1980s, asset-backed securities (ABS) have grown and evolved into new types of securitization in the form of auto loans, cell phone payments, aircraft leases and credit card receivables. Today the ABS market is $1.6 trillion, according to a 2018 Securities Industry and Financial Markets Association (SIFMA) report and comprised of many asset types that offer vast diversification potential.
The ABS market declined after the 2008 financial crisis but rebounded in 2013 with an expansion in to non-traditional categories. Despite its considerable growth, ABS remains the smallest subset of fixed-income securities. Small, however, does not mean illiquid or risky. Deal structures allow investment managers to determine the level of risk they are willing to assume. However, identifying inefficiencies requires a deep and nuanced understanding of the space.
Consumer products and loans is an attractive area of the ABS market. Consumer lending has emerged as another way to finance unsecured loans outside traditional financial institutions. For investors looking for shorter duration investments of less than one, consumer products often provide additional spread. The risk/reward trade-off is similar to buying AAA-like credit without the AAA-moniker, which can result in anywhere from 30 to 100 basis points in spread.
As a relatively young sector, most ABS issuers have not solicited or received the coveted AAA-rating. Ratings agencies currently cap at single-A for ABS that lack extensive histories. For those assets that tend to be short duration it is inefficient for the issuer to go through the rating process. Oftentimes, if it’s a short-term loan that’s been securitized, the loan will be paid off before receiving a rating. By going to the nonrated space, the issuer ends up saving money and passes some of that savings on to the investor.
Some managers might be inclined to avoid names that aren’t rated or have limited histories. An experienced manager can extrapolate other data to test the types of environments a bond can withstand. Portfolio managers can stress test credit to determine how it would perform in an environment like 2008 or during a future recession. It’s possible that a bond may not see a loss in a particular scenario but face a downgrade or mark-to-market loss. It’s up to the investment manager to determine whether the risk/reward trade-off is worth it.
Some of the newer, non-agency mortgages are also attractive, coming in a variety of structures and offering a favorable risk/reward profile for the high-quality AAA-rated space. Volume has slowly ramped up in the last couple years, with demand likely driven by the increasing number of borrowers who can’t get conventional mortgages, as well as by lenders who have gotten more comfortable with credit risk and have entered the space after seeing the performance. The buyer base has expanded with the increased volume and, even though spreads are a bit tighter, the increased liquidity has its appeal.
The ABS market has continued to evolve over the past few years with emerging securities based on diamonds, agricultural crops and venture capital. Investors can expect even more offerings as they hunt for diversification. But asset managers can miss opportunities if they focus too much on ratings or overall credit metrics and neglect the quality of individual investments.
Firms with nimble decision-making processes can seize opportunities that might be out of reach for firms who must seek committee approval or produce formal write-ups when new issuers come to market. As issuers become more established spreads can tighten up significantly in the few years it takes for less nimble firms to become comfortable participating in the ABS market. Firms that have thoroughly assessed the market and are able to react quickly when new issues are released can pick up bonds cheaply on the secondary market once spreads wind down.
The ABS market is fluid, with a wide variety of structures and opportunities for investors who are prepared for the flow of new assets into the space and can detect mispriced opportunities. These investors benefit from bottom-up analysis to exploit pricing inefficiencies, and a deep understanding of deal structures and the companies bringing them to market. The best ones know how to apply a bottom-up security analysis and prioritize independent thinking over universal benchmarks and ratings.