Student loan ABS, beyond the headlines
Finding value in a frequently misunderstood sector.
Like auto loans and credit card debt, student loans are securitized as asset-backed securities (ABS) and are a component of short-duration strategies such as ultrashort bonds. Given the abundance of concern about what is often referred to as the “student loan crisis,” we asked Senior Investment Analyst Dan Mastalski to provide some clarity.
Q: How much of the overall ABS market is comprised of securitized student loans? Student loan ABS comprise roughly 10% of total ABS new issuance but make up approximately 20% of outstanding ABS. The difference in these figures can be attributed to longer repayment periods on student loans relative to other consumer debt, which leads to a longer-weighted average life and bond maturity on the corresponding security.
Q: What benefits do student loan ABS offer to fixed-income strategies like ultrashorts? In addition to providing diversification in a securitization market that has become increasingly reliant on auto originations, student loan ABS is a key source of floating-rate exposure. Through mid-October 2021, floating-rate issuance has totaled just 5% of the ABS market. However, within student loan issuance this year, roughly 40% has been floating rate.
Q: Do high default rates and loan forgiveness programs have a negative impact on student loan ABS? Despite the scary headlines, we don’t view this as a problem in terms of the securities in which we invest, which are primarily U.S. government-backed loans. In fact, federally backed loans make up approximately 92% of the student loan market.
If loans issued under the U.S. Department of Education were to be forgiven, the obligation to repay the investor is almost entirely (97-98%) incumbent on the Education Department—ultimately, taxpayers like us. The other 2-3% would be covered in the structure of the transaction—that is, the securitization would carry approximately 5% credit enhancement to make up that remaining payment. Keep in mind that just because the loan has been forgiven doesn’t mean the investor wouldn’t get paid. Prepayment of these loans could even be considered a benefit given that the loans would be paid off more quickly by the U.S. government.
Q: What about risks related to private student loans? Unlike federal in-school student loans with no underwriting requirements, private refi and in-school student loans are underwritten to a fairly high standard. The typical refi student loan borrower has a graduate or doctorate degree, is a high earner with a high FICO credit score and has been making student loan payments for several years. Meanwhile, in-school student loans are generally made to students seeking four-year degrees at not-for-profit institutions, and benefit from the inclusion of a creditworthy cosigner, typically a parent. More than 90% of loans issued to in-school borrowers are underwritten with a cosigner, for which all payment responsibilities are shared. So, for example, if a recent graduate is unable to find employment sufficient to make payments on their student debt, the obligation of the cosigner typically mitigates future defaults.
As for impacts from loan forgiveness, so far, no specific details of any private-sector forgiveness program have emerged. But it is fair to say that any forgiveness of debt to the individual would still have to be made whole at the security level. That is, the government would still be “on the hook” for repaying bondholders. This also would be the case for student loans funded by private lenders through the federally insured (FFELP) program, which was discontinued in 2010.
Q: Also mentioned as a potential issue is the increase in student loan payment extensions. Part of our credit research involves analyzing any deal to make sure we buy cash flows that won’t run afoul of loan extension issues. Therefore, even if the rating agencies indicate that a student loan is in default because payments are being made beyond the legal stated final maturity of the security (due to means-based repayments), our research will determine whether those payments are still being made on schedule. So, while these bonds may be in default technically, this is often more about semantics. Historically, these securities have traded like the AAA-rated securities that they are.
Q: A number of student loan servicers—such as the Pennsylvania Higher Education Assistance Agency, Granite State Management and Navient—have either exited or expressed interest in exiting this market. Is that a concern? While servicing transfer is a potential cause for concern in FFELP pools, we believe the process put in place by the Education Department to alert borrowers of the transfer as well as to ensure the smooth transition from one servicer to another is satisfactory. In private student loan deals, we assess the quality of both the primary and backup servicer. The presence of a competent backup servicer minimizes the risks associated with the transfer of servicing responsibilities, should it become necessary.
Q: Overall, how does the investment team manage potential risk in student loan ABS? Managing potential risk in student loan ABS is similar to our approach for managing risk in other ABS asset classes. We seek bonds that are backed by high-quality collateral, originated by a strong sponsor and serviced by an experienced servicer. Once those conditions are met, we assess whether deals are adequately structured to both protect against interest shortfalls and reduce risk of principal loss. Although the underlying collateral type may change, we seek consistency in our analysis process.