Rates uncertainty prolongs ABS buying opportunity

With fresh uncertainty surrounding the path for interest rate cuts, we believe the high current income and typically lower volatility offered by European asset-backed securities (ABS) and Collateralised Loan Obligations (CLOs) make them an attractive allocation option for this stage of the cycle.

As a predominantly floating rate asset class, European ABS has proven its worth to fixed income investors in recent years.

Having done its job of delivering lower volatility and better performance than mainstream credit in the bond market mauling of 2022, the combination of higher rates and ABS’s higher spreads have made it one of the top performers across global fixed income in the two years since.

When interest rates come down, floating rate products such as ABS lose some of the direct yield boost they gained when rates were rising. But with recent political events trimming rate cut expectations and higher spreads ensuring ABS retains a yield premium over more mainstream fixed rate bonds, we think the asset class remains an attractive allocation for this stage of the cycle.

Higher-for-longer income

The Bank of England (BoE), European Central Bank (ECB) and Federal Reserve (Fed) have all begun to cut rates this year as inflation has receded. But as Exhibit 1 shows, market projections for rate cuts have been pared back markedly in recent weeks.

In the UK, the extra borrowing unveiled in the new Labour government’s first Budget in October is expected to bring a short-term boost in growth that will limit the BoE’s capacity to cut rates. In the US, the tax cuts and tariffs proposed by Donald Trump on his way to winning the presidential election in November are widely considered to be inflationary, which has weighed on market expectations for US rate cuts.

This shift in expectations for the next 12 months or so is naturally a positive for floating rate assets such as ABS. Given ABS coupons generally move up and down in line with base rates, higher-for-longer rates would mean higher-for-longer income.

Rate cuts welcome for ABS asset pools

While European ABS investors will largely welcome the slower pace of rate cuts now being priced in, the handful of cuts central banks have put through so far have helped ease concerns around any deterioration in asset performance.

With growth slowing and consumers facing tighter financial conditions as a result of rate hikes, historically weaker sectors such as “non-prime” auto loans in the UK, where payment arrears have increased in recent months, are one example of an asset type looking less and less attractive.

Prime borrowers though have proven resilient to higher rates, with performance across the major European residential mortgage-backed securities (RMBS) markets still very strong (see Exhibit 2). With banks increasingly using ABS as a funding tool as they look to replace cheap facilities from central banks, investors have access to a growing universe of prime collateral at a point in the cycle when we believe it is prudent to focus on stronger borrowers.

More importantly, however, we think the latest shift in rate expectations will benefit one of the highest risk (and highest yielding) areas of ABS investors often look to allocate to, which is European CLOs. 

Looking back to Exhibit 1 above, the clear exception to the trend of fewer expected rate cuts has been the Eurozone. The weak growth outlook in the “core” economies, particularly Germany, means markets expect the ECB to cut rates by a further 125 basis points (bp) to around 2% over the next 12 months.

Leveraged loans – loans to more indebted companies that make up the vast majority of CLO portfolios – are typically floating rate, so rate cuts directly reduce funding costs for these companies and should generally bolster CLO collateral performance.

This exposure to riskier corporate borrowers has made CLOs one of the more volatile areas of ABS when market sentiment has deteriorated. However, they have historically shown extremely low default rates through multiple rate cycles (see Exhibit 3). Since 2002, the annual default rate for global sub-investment grade (IG) CLOs has remained below 1% – for European CLOs issued post-2008 the rate is 0% – compared to a long-term average default rate of 4% for global sub-IG (high yield, or HY) corporate bonds.

ABS relative value still stands out

It is also worth remembering that fixed rate bonds are far from immune to falling rates. Rate cuts are certainly favourable for fixed rate bonds since their fixed coupons look more attractive in the new rate environment, which can lead to capital gains for holders as their prices rise. However, markets are quick to price future rate expectations into fixed rate markets, so purchase yields for newly-issued fixed rate bonds also tend to fall in a declining rate environment.

When rates are falling, investors tend to seek out higher spread products as they look to maintain yield.

European ABS and CLOs are typically two of the highest spread markets in fixed income. The effect of these higher spreads can be seen in Exhibit 4, which shows yields over a forward curve; this takes into account the expected change in interest rates currently being priced in for the next 12 months, so it effectively looks to convert the ABS and CLO yields in the table below to fixed rate yields for a better comparison.

As the table shows, both AAA and BBB rated European CLOs retain a significant premium over corporate bonds of a similar rating thanks to their higher spreads, and that premium has been relatively stable even as rates have dropped.

Another potential advantage of ABS at this stage of the cycle is its typically lower volatility versus more mainstream fixed rate bonds.

Given how anxious both central banks and investors are about a potential resurgence in inflation (recent rises in core inflation have confirmed the issue is far from dead), and now with the added uncertainty of President-elect Trump’s tariff plans, we think the recent volatility in fixed rate bonds is likely to continue as expectations fluctuate.

By contrast, the near-zero interest rate risk of European ABS could be a valuable source of stability for fixed income portfolios in the coming months. In addition, in contrast to fixed rate bonds, if rate cuts do fall short of market expectations over the next 12 months then ABS and CLO yields would end up above the current forward projections, without the price of the bonds being impacted.

High income and lower volatility

While a declining rate environment is logically a negative for floating rate assets, we think a backdrop of renewed concern over inflation, the unknown impact of US tariffs and heightened geopolitical risk has prolonged the buying opportunity in European ABS.

With high current income, healthy collateral performance and better relative value than mainstream credit (along with historically lower volatility), we continue to see European ABS as an attractive allocation option for this point in the cycle.