Why now for ABS: healthy consumers and attractive income

It has been a difficult couple of years for consumers. Across the world households have had to grapple with a cost-of-living crisis that has eaten into disposable incomes and forced them to think twice about the purchases they are making.

Inflation has dramatically pushed up the prices of everything from gas and electricity to food and clothing and, as central banks globally have attempted to rein in rising prices by ratcheting up interest rates, this has created further financial pain for both home owners and renters.

Despite the crunch on consumers, however, they have proven exceptionally hardy, with their financial health remaining remarkably strong during a very difficult period. Credit card delinquency rates may have crept up and the number of people in Europe rolling onto higher fixed-rate mortgages is increasing, but consumers by and large continue to be cushioned by the excess cash they built up during the Covid-19 outbreak. 

Hardy consumers

A resilient consumer is key for any well-functioning market, but it is particularly important for asset-backed securities (ABS), which are generally issued by banks and secured against many, many assets with regular repayments and similar characteristics, such as mortgages, credit card debt and car loans. 
Although households have had to contend with one of the most aggressive rate-hiking cycles on record, the sense is that the successive and rapid increases enacted by central banks across the globe have come to an end.

Despite this, mortgage borrowers in Europe are stress-tested at significantly higher rates than those we are currently experiencing, providing additional comfort that homeowners can withstand the current interest-rate levels.

And, with longer-term fixed-rate mortgages common in Europe, this has helped shield most consumers from the immediate impact of rising interest rates, limiting the proportion of the population that have had to refinance at peak levels. In countries like the Netherlands, where a typical mortgage term can be up to 30 years, most borrowers are able to avoid these peaks entirely. In the UK, however, more borrowers have increasingly opted for five-year fixed mortgages, which means that they are more sensitive to rate rises, but equally they are stress- tested for significant rate hikes. And what the last 18 months have shown is that borrowers resetting to higher rates have been able to afford these new rates, with arrears levels remaining at all-time lows.

Meanwhile, within the CLO market companies have been proactive in addressing their maturities and sponsors have shown support by injecting new money where needed. For this reason, the spike in default rates that we expected to occur has not materialised, which has also been helped by better-than-expected earnings due to a portion of companies having interest hedging in place as well as a less severe macroeconomic backdrop.

A soft-landing

The base case for most investors, including our own house view, is one of a soft landing for the global economy. But in any case, for the ABS investor, the advantage is you are effectively being paid by the pool of loans backing the bond, rather than the company you are buying the bond from, with that money being ringfenced. 

If the issuing financial institution or bank was to go bankrupt, your coupons would continue to be paid, since the underlying borrowers in the loan pool are still making their payments each month.
Structural features are also built into European ABS to protect investors, which makes defaults extremely rare.

In the residential mortgage-backed security market (RMBS), for example, these deals are structured in a way that they include a number of protections to cope with periods of crisis and disruption to performance, which are designed to keep bond payments flowing even during acute moments of stress.

These include:

• Home owners’ equity, where the first lost is absorbed by residents. Average loan to value in the UK is around 70%, and this would need to be entirely wiped out to expose shortfalls. 
• Excess interest, where essentially the bank’s profits form a cushion. If we assume the mortgage holders pay 4% on a monthly basis, but only 3% of this is needed to pay noteholders, the banks receive 1% as excess interest on a regular basis. This is the bank’s profit margin in the deal, and this profit is the first layer of structural protection as mortgage losses are netted against the deal profit.
• Additionally, there will be a reserve fund - a ring fenced pool of cash that is created when the RMBS structure is set up and capitalised by the bank. Its sole use is to protect the noteholders and is used when interest and repayments from homeowners do not cover payments. If used then the reserve fund will be topped up back to target in the future before the bank gets paid any profit margin.
• If this isn’t enough then ultimately losses will be allocated to the most junior bonds first and senior bonds benefit from this subordination.

Low unemployment

The key driver of consumer performance is almost always unemployment, and, right now, it is at or very near historically low levels.

Unemployment has crept up very slightly and further increases are expected, but it is much lower than in previous cycles, and is well within what the stress-testing of an ABS structure indicates it can handle. Also, strong wage growth in countries such as the Netherlands and the UK continues to support incomes.

Labour markets are slowing, as is growth in wages across Europe, but with inflation also descending rapidly, real incomes have improved. We think this explains why consumer confidence is strengthening, albeit from a low base, with spending patterns having proved robust.

And, especially at a time of uncertainty, we think ABS can provide a lot of downside risk mitigation compared to other asset classes, including natural deleveraging, structural protection, and diversification away from corporates. 

Higher for longer?

European ABS are virtually all floating rate, with near-zero interest rate risk, which means they’re expected to be far less volatile than fixed rate bonds when interest rates are rising. But, even in the current environment of predicted rate cuts, we believe ABS continues to have a powerful role to play. 

The stronger-than-expected macroeconomic picture means central banks look less inclined to cut rates at the levels predicted at the end of last year and when they do we think it is likely they will fall only moderately, which means the income on ABS in Europe is particularly attractive and predictable in our view. 

How many and the pace of cuts likely taken by the European Central Bank and the Bank of England are unclear. For that reason, we continue to be positive about the role of European ABS as a floating rate investment and, with possibly elevated volatility for the rest of 2024 due to economic uncertainties, the current income available is very valuable still.

All of this should be positive for ABS, and that is without the diversification benefits the asset class brings. It has a different risk profile to other areas of fixed income given ABS directly invests in the cashflows generated from assets, rather than those generated by corporates. This, in turn, has historically led to less of a correlation to wider markets, providing positive diversification benefits.

If you are nervous about where things might go from here, we think European ABS offers a unique diversifier, that naturally de-risks throughout its life. And so, while the ABS market can sometimes look like a confusing alphabet soup of acronyms, the benefits right now are clear.