How is the pandemic affecting ABS investing?
In addition to being a standalone investment, asset-backed securities (ABS) are a component of many fixed-income strategies, favored for their high quality, shorter duration and ability to support portfolios with a diversified source of yield. Much of the ABS market is based on consumer debt—auto loans, credit cards, insurance premium receivables and other shorter-term assets. We asked Senior Portfolio Manager Randy Bauer for his take on the state of the ABS market during this period of economic uncertainty.
Q: Are you concerned about the stability of the ABS market given the economic fallout from the coronavirus?
It’s important to differentiate between the liquidity crunch that drove markets downward during the early stages of the pandemic and the economic downturn in which the U.S. economy now finds itself. The massive support programs enacted by the Federal Reserve and Congress have addressed the former issue, and all markets, including ABS, have settled down appreciably.
One of the Fed programs, the Term Asset-Backed Securities Loan Facility (TALF), is intended to help lenders meet the credit needs of households and U.S. businesses by supporting the issuance of ABS going forward. The TALF announcement has clearly provided a floor to the ABS market. In fact, current issuance of ABS securities occurred even before the commencement of the program, with clearing levels at lower yields than would be contemplated by using TALF to issue securities. This indicates that the market has indeed stabilized. It is likely that the program will still be used for the issuance of less broadly distributed asset classes where market spreads tend to be wider.
As for the pandemic’s effect on the performance of various types of ABS, that ultimately will be dictated by the progression of the virus. Federated Hermes analysts continue to stress-test our ABS holdings under severe economic contraction scenarios, and we are comfortable that the robust structures associated with the securities held in our portfolios will allow them to withstand the severe current dislocation.
Q: What is the default history of ABS?
In general, the ABS marketplace is very high quality: approximately 75% is AAA-rated. Its default history is actually lower than that of the corporate bond market, comparing default statistics of similarly rated securities.
Also, since the 2008 financial crisis, the ABS market has improved in quality with better underwriting and higher levels of enhancement—such as larger subordinated tranche sizes, more over-collateralization and better quality assets. But even during the financial crisis, Federated Hermes portfolios did not experience problems with ABS investments (defined as non-mortgage-related securitized assets). A big reason is the depth of our credit research.
Q: How are you navigating current and potential volatility?
We navigate volatility, first and foremost, through a stringent credit review process that never changes, regardless of market conditions. So while we reference credit agency ratings, Federated Hermes investment teams rely on our own fundamental credit analysis as the primary determinant of risk. The process is extremely thorough and involves continuous monitoring of securities within our portfolios. In our evaluation of asset-backed issuers we research:
- Asset quality and resale value
- Borrower quality
- Deal structure, including creditor payment terms and protection
- Quality and servicing of receivables
- Types of receivables – auto, credit card, equipment, etc.
- Management commitment to securitization
- ESG considerations at sponsor and collateral levels
Our approach involves analyzing both the collateral (i.e., the underlying assets) and the sponsors (i.e., the originators of the loans and receivables, including banks, financial companies and credit card issuers). Where applicable, we collaborate with our corporate bond management teams to benefit from their research on any corporate issuer that we are reviewing.
We also research the loan structure, the cash flow waterfall—that is, how is the cash flow paid from the underlying loans to the bonds themselves? This information is explained in the indenture of the ABS. We also look at the quality of the loan servicing, which is typically done by the sponsor and is an essential consideration.
Bottom line, we only invest in those securities that pass this intensive research process. Our experience over decades has shown that this is best way to navigate volatility and unpredictable markets.