As the Wave of Central Bank Purchases Crests, ABS and CMBS Offer Shelter in the Break
Through the third quarter of 2017, global fixed income markets remained buoyed by central bank purchases. Each month, the central banks of the U.S., Europe, and Japan purchase roughly $50, $70, and $60 billion, respectively, of government and corporate bonds to stimulate their economies and boost asset valuations. Combined, they now hold one-fifth of all global bonds. The impact of this enormous positive technical is undeniable. German and Japanese 10-year yields hover near zero. U.S. credit markets offer investors less compensation today than at any point since 2006. The figure to the right shows the Bloomberg Barclays U.S. Credit index spread over U.S. Treasuries is at the lowest level in a decade, whether measured for all investment grade bonds or just BBB rated notes.
The tide of unprecedented monetary support has likely crested. In September, the Federal Reserve (Fed) announced its plan for the largest position unwind in financial history. It begins modestly, with monthly reductions in purchases of $4 billion for agency mortgage-backed securities (MBS) and $6 billion for U.S. Treasuries. The pace of tapering ramps up to monthly reductions totaling $50 billion by the end of 2018. The Fed aims at a gradual, well-communicated reduction of its balance sheet. But, their “watch the paint dry” hopes for unwinding a $4.5 trillion bond portfolio may clash with a reality of sharp U.S. rate and spread reactions, as experienced during the Taper Tantrum of 2013.
Longer duration, lower quality credits are particularly exposed, and U.S. tax reform (handicap the political prospects as you may) adds further uncertainty to the rates outlook. The Senate budget blueprint anticipates at least $1.5 trillion in tax cuts, at a time when unemployment is low and federal debt is high.
Short, high quality asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), however, continue to offer stability, value and safety. ABS and CMBS have performed well during periods of both rising rates and credit market sell-offs. The ABS market continues to expand, particularly in subsectors other than traditional prime auto and credit card ABS. Hundreds of well-established companies have diversified their funding sources away from bank borrowing and now issue ABS debt in the capital markets. The continued supply growth underpins the attractive valuations BBH finds across more than 30 market subsectors. Later we explain why we expect such compensation to persist.
At the end of Q3, the BBH Structured Fixed Income Strategy representative account had a yield of 4.2%, an interest rate duration of 2.2 years, a spread duration of 2.7 years, and was 97% investment grade. During Q3, the BBH Structured Fixed Income Strategy composite returned 1.4%, while the Bloomberg Barclays ABS Index returned 0.4%. Since its inception in January, 2016, it has returned 5.3% annually compared to 2.05% for the Bloomberg Barclays ABS Index.
Opportunities in ABS and CMBS stand out amid frothy credit markets
Despite frothy valuations in larger, on-the-run corporates, BBH’s strong issuer relationships, early access to new issuance, and secondary sourcing capabilities resulted in our adding new ABS and CMBS positions at compelling valuations.
Attractive spread concessions are typical from infrequent issuers and new entrants to the ABS market. For example, Willis Lease Finance is the largest independent lessor of aircraft engines to airlines worldwide. Willis finances its leased engine portfolio through periodic ABS issuance. In July it completed its fourth securitization since 2005. The transaction is collateralized by 56 aircraft engines on lease to a diverse group of 27 airlines and mounted to the newest generation, in-demand narrow body aircraft. BBH discussed this deal with Willis for more than two years before the transaction occurred. As a result, we were able to lock up our desired allocation of the 6-year duration, triple-B rated tranche at an attractive 6.75% yield. This represents a sizable spread of 460 basis points1 (bps) over U.S. Treasuries for a tested, dependable credit. Every airline has a continuing operational demand for extra engines to replace those engines undergoing periodic maintenance, as dictated by FAA regulation. Demand for leasing replacement engines is particularly strong during periods of weaker airline profitability. The engine lease market is countercyclical and exhibits stable utilization rates. Willis’ historical utilization rates have ranged from 83% to 93% over their 30-year history.
BBH was also an early participant in the first issue of a venture debt backed ABS transaction originated in a collaboration between Silicon Valley Bank (SVB) and West River Group (WRG). Since 1982, SVB has been the industry leader in venture debt lending to late stage life sciences and technology companies. The loans are underwritten at very low loan-to-value ratios of 7% to 15% to firms with strong venture capital backers. Historical loss rates on venture debt loans are low, less than 1% annually, even through periods of industry stress such as the dot-com bubble. BBH established the final pricing for this 3-year duration, triple-B rated transaction at a yield of 6% which equates to a 450 bps spread over U.S. Treasuries. Secured by a diversified pool of loans, the notes benefit from 7% annual excess loan interest as well as a 30% equity retention beneath the ABS debt. These structural protections assure the notes can withstand a 500% increase in our base case loss estimate with zero impairment of interest or principal.
In CMBS markets, owners of legacy, pre-2008 positions have been redeploying large principal paydowns into new CMBS issuance. Heavy demand has capped spreads and valuations in primary markets. However, pockets of real estate concerns and portfolio liquidations continue to generate attractive opportunities in secondary markets, several of which our team sourced last quarter. For example, we added triple-B rated single-borrower CMBS, secured by a diversified portfolio of Hudson’s Bay stores, at a 7.3% yield. This represents a 524 bp spread over U.S. Treasuries. The underlying loan is secured by a 34 store portfolio of many of Hudson’s Bay’s strongest performing store properties in leading regional malls in the U.S. Hudson’s Bay Company, Canada’s largest department store owner, and retail real estate investment trust (REIT) leader Simon Properties Group jointly manage and hold the equity beneath these notes. Average portfolio store sales are 30% above national chain averages and the notes have a 45% loan-to-value ratio.
Attractive ABS compensation persists
ABS and CMBS offer yields of 50 to 400 bps over corporate bonds and traditional prime auto and credit card ABS of similar maturity and credit quality. These yield concessions cannot be explained by differences in credit, liquidity, or volatility. Instead, they are the result of a persistent supply/demand imbalance described below.
Increasing Supply: After the Financial Crisis, manufacturers and non-bank finance companies prudently diversified their sources of borrowing away from banks to include the issuance of ABS in the capital markets. Issuance of non-traditional ABS2 has risen from $14 billion in 2008 to $122 billion in 2016, resulting in a broadly diversified, $470 billion asset class comprised of more than 30 distinct subsectors.
Stable Demand: In contrast to this increasing supply, the demand for non-traditional ABS remains concentrated within a stable group of investors – approximately 15 to 30 asset managers and a similar number of insurance companies. BBH remains the only asset manager to offer a product dedicated to performing non-traditional ABS. Investor demand for this sector is constrained for a variety of reasons, all of which indicate that these spreads are likely to persist:
- Small Deal Size: The typical asset-backed deal size of $200 million to $1 billion is simply too small to interest many large money managers.
- High Barriers to Entry: Success in this asset class requires a large resource commitment to underwrite over 30 subsectors. This entails specialized expertise and significant experience.
- Little or No Fixed Income Benchmark Representation: Few non-traditional ABS are included in the widely referenced aggregate fixed income benchmarks. As a result, the sector is largely untouched by the sizeable and growing universe of passive investors, index funds, and exchange-traded funds (ETFs).
- Arbitrary Investment Policy Restrictions: Many investors limit or prohibit the use of 144a securities or require ratings from a particular ratings agency, often Moody’s and S&P. These restrictions substantially limit the set of investors because many ABS are rated by other ratings agencies.
- Tarred by Association: Many investors mistakenly conflate non-traditional ABS with non-agency residential mortgage-backed securities (RMBS). During the Crisis, however, non-traditional ABS credit performance was very strong while RMBS credit performance was abysmal.
- Misperceptions: A common misperception is that higher yields reflect inexperienced issuers and novel products. In fact, new issuers are typically experienced underwriters. While ABS issuers may be new to the capital markets, most issuance (and all BBH purchases) are from long-standing companies with decades of experience that profitably underwrite time-tested lending products and retain substantial equity in their deals.
The figure below not only illustrates the ongoing spread advantage of non-traditional ABS sectors (blue) over similarly rated corporates (green) and traditional ABS (brown).
September’s tragic storms inflict negligible damage on ABS and CMBS trusts
Although clearly devastating to those affected by recent hurricanes Harvey, Irma, and Maria, the performance ramifications to ABS and CMBS trusts from wind and flooding damage are modest.
For example, auto lender Santander estimates its disaster-related losses to rise only moderately in affected localities — 3.5% in Florida and 5% in Houston. It is important to note that the vehicles that collateralize auto loan ABS must be insured by their owners. Further, the abrupt removal of more than one million vehicles from the national automobile stock may actually boost used auto values and loan recovery rates upon default. Accordingly, Santander estimates only a minimal impact to their overall U.S. auto loan portfolio. Similarly, credit card and personal consumer ABS issuers, backed by highly diversified U.S. loan portfolios, did not exhibit an increase in delinquency rates after the hurricanes.
There was also no major wind or flooding damage to the retail and office properties that secure our single-asset CMBS trusts. Even in the event of a direct storm hit, these properties carry full property and business interruption insurance coverage. Conduit CMBS deals (which are diversified over 100 properties or more) benefit from a more geographically diverse loan portfolio, but individual loans may have lesser insurance coverage. Our conduit CMBS holdings experienced no material impact from the hurricanes. More generally, JP Morgan estimates that the 39 U.S. counties identified by Federal Emergency Management Agency (FEMA) as disaster areas contain $29 billion of loans representing 3% of CMBS collateral. Widespread impact to conduit CMBS transactions is unlikely, but individual deals may experience some hardship, particularly those with larger Houston-area loans.
Milestone for CMBS – the overall market size is now growing
The non-agency CMBS market passed a milestone in Q3 – monthly net issuance of non-agency CMBS turned positive for the first time in several years (see figure to the right). This is because the pace of maturities of 10-year loans from 2007 transactions diminished and new CMBS supply was brisk, particularly in single-asset, single-borrower (SASB) CMBS. Given the dearth of CMBS origination from 2008-11, the outstanding CMBS market should continue to grow meaningfully. While solid crossover demand from investment grade corporates continues to keep spreads firm in new issue CMBS markets, growing market supply will cause technical headwinds to CMBS in the coming months.
For example, we recently saw some evidence of a softening in the market, as spreads on BBB tranches of recent conduit issuance widened moderately on late September and early October deals. The increased pace of new conduit supply in September contributed to the widening. We still find the compensation currently available in new conduit and SASB issues too low relative to their underlying credit fundamentals. However, we expect the building CMBS supply to weigh on markets into year-end. Meanwhile we continue to find value in secondary CMBS markets.
ABS markets expand in size and breadth
Although ABS issuance typically slows in July and August, we witnessed strong new transaction volume in the third quarter (see figure below). Total 2017 issuance, $164 billion year-to-date, remains on pace to set a post-Crisis record. Growth continues to be robust and broad-based with rising issuance and new entry by well-established companies/management teams in over 30 commercial and consumer subsectors other than traditional prime auto and credit card loans. U.S. Chief Financial Officers’ corporate imperative to diversify sources of funding is driving industry after industry to the ABS market, while declining auto sales and cheap bank deposits diminish issuance in the more traditional ABS subsectors. For example, of the 63 ABS transactions in the third quarter, 50 represented less traditional industries such as large equipment lease, aircraft lease, personal consumer loan, auto floorplan and subprime auto loan ABS. There are numerous ABS subsectors, but each may include just two to five issuers who are less familiar to the investor community. As a result, issuer equity retentions, required note structural protections and offered compensation are all greater for these ABS subsectors than among the prime auto and credit cards sectors.
Presently, U.S. credit spreads are tighter than at any time since 2006. The quantitative easing (QE) that buoyed credit markets since the Financial Crisis is waning. This may present a challenging scenario for bond investors. However, the ABS in which BBH invests continue to offer safety, stability, and value. Our representative account has short rate and spread duration (2.2 and 2.7 years, respectively), high credit quality (97% of the portfolio is investment grade), good liquidity, and a yield to maturity of 4.2%.
The spread concessions available over corporate bonds and traditional prime auto and credit card ABS cannot be explained by differences in credit, liquidity, or volatility. Instead, they are the result of a persistent imbalance between supply and demand. On the supply side, this is driven by hundreds of well-established companies that have diversified their funding sources away from bank borrowing and now issue ABS debt in the capital markets. The demand for non-traditional ABS, however, remains concentrated within a stable group of investors. Investor demand for this sector is constrained for a variety of structural reasons, discussed earlier in this Strategy Update… suggesting that attractive spreads will persist.
Neil Hohmann, PhD
Head of Structured Fixed Income and Portfolio Co-Manager
Andrew P. Hofer
Head of Taxable Fixed Income and Portfolio Co-Manager
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© Brown Brothers Harriman & Co. 2017. All rights reserved. 10/2017.
IM-2017-11-02-4505 Exp. Date 01/31/2018
1 A unit that is equal to 1/100th of 1% and is to denote the change in price or yield of a financial instrument.
2Traditional ABS includes prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS includes ABS backed by other collateral types.