Investors hunting for better returns are doubling down on risk in far flung corners of the U.S. bond market.
Nowhere is this more striking than in the markets for asset-backed securities and collateralized loan obligations. Below-investment-grade ABS are on track this year to account for its biggest slice of the overall sector since before the financial crisis. At the same time, the riskiest CLO notes are now a larger percentage of the market than they’ve been in two years.
The growing appetite for the lowest-rated bonds in the ABS and CLOs markets highlight the rabid demand for higher-yielding securities and those with floating rates that offer protection from inflation and tighter monetary policy. But this also leaves these markets more exposed at a time when many analysts see an economic slowdown on the horizon.
“From a debtholder’s perspective, I am very wary of these types of lower-rated tranches, as they have been shown to have much more spread volatility and much more rating risk,” said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management, about the collateralized loan obligation and asset-backed securities markets.
Subprime ABS
The supply of below-investment-grade asset-backed securities in consumer categories has been rising for the last two years with the majority in personal loans, equipment and auto, according to Wells Fargo.
Subprime auto ABS is the largest category. Companies have sold more than $150 million of B rated bonds in the sector this year, compared with nothing last year and an annual average of about $20 million since the financial crisis, Barclays analyst Alin Florea wrote in a recent note. It’s still a small part of the overall market.
The popularity of subprime auto ABS -- especially the rise of B rated tranches -- is a concern because there are fewer protections baked into the structures of the deals than before the financial crisis, S&P Global Ratings analysts said in a note Monday.
Bonds rated BB typically were insured in the 1990s, featuring important triggers to protect investors. But insurance hasn’t been used as a form of credit enhancement in this market since 2008, so the latest batch of subprime deals -- many of which now go all the way down to B ratings -- doesn’t have the same safety net, according to S&P.
“Given the lack of triggers and the growing popularity of B rated classes in subprime auto loan ABS, the market is bearing similarities to the speculative corporate bond market where covenant-lite structures are abounding,” S&P analyst Amy Martin wrote. “The low-interest-rate environment and low default history has resulted in an increasingly borrower-friendly leveraged finance condition as investors seek higher yield.”
Bundled Loans
The share of deals issued with B rated tiers in the CLO market has increased to 30 percent of new issues compared with 17 percent last year and 3 percent in 2016, according to Nomura.