Prepared for Recession? ABS Were Built Against One
U.S. credit markets languished late last year as market sentiment soured on corporate downgrades, U.S. trade policy, and the prospects for slowing global economic growth. During the fourth quarter, U.S. loan and credit funds experienced sizable outflows.
Commencing January 4th, however, Federal Reserve (Fed) Chairman Jerome Powell signaled in multiple speeches a new readiness by the Fed “to be patient” with its monetary policy, delaying both rate hikes and the drawdown of its balance sheet. As quickly as market sentiment had turned negative on credit in December, risk assets snapped back in January based on the Fed’s more dovish stance and growing optimism over trade agreements. The S&P 500 jumped 14% in the first quarter, and corporate credit spreads retraced much of their fourth quarter spikes.
Concurrently, the pause in rate hikes and the prospect for future rate cuts drove U.S. Treasury rates broadly lower in the first quarter. Two-, five-, and 10-year Treasury yields declined 22 basis points1 (bps), 28 bps, and 27 bps, respectively. With this flattening, the Treasury yield curve definitively inverted. On March 31, two-year yields, at 2.26%, exceeded 5-year yields by 3 bps.
With a more accommodative Fed and a flattening yield curve, corporate credit enjoyed strong first quarter performance. The Bloomberg Credit Index returned 4.9%, and the 1-3 Year Credit Index returned 1.7%. This credit rebound, while welcome, unfortunately puts fixed income investors into an even tougher bind than last September. Credit spreads are once again near cyclical tights. Rates also hover near historical lows. And extending rate duration makes even less sense with an inverted curve. Volatility, both in technicals (fund outflows, foreign selling, and diminished liquidity) and in fundamentals, still plagues corporate credit broadly. Finally, at quarter’s end, dour global growth forecasts further fanned fears of a near-term U.S. recession.
Amid this very challenging environment for fixed income investors, a strategy of investing in non-traditional2 asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) continues to offer numerous advantages. These assets offer substantially higher compensation than comparably-rated corporate bonds and traditional prime auto and credit card ABS. For example, the average yield of BBH’s Structured Strategy (the “Strategy”), a portfolio of non-traditional ABS and CMBS, is 4.7% as of March 31, 2019.3 representing a spread over Treasuries of 229 bps. Liquidity is good, between 10 and 30 bps on a bid/ask spread basis, and 85% of the portfolio is rated investment grade. The correlation to the broader credit market is low – the 6-month rolling beta4 of the Strategy to the Bloomberg Barclays U.S. Credit Index is less than 0.3.
And notably, the rate and spread duration of the assets in the Strategy average 2.1 and 2.7 years, respectively. This short duration reduces price volatility from rate and spread movements, and is also near the peak rate along today’s inverted Treasury curve. The price stability of these assets is readily apparent in one- and three-year actual returns of the Strategy (see tables below). The standard deviation of annual returns is only 0.8% annualized over the last three years.
With an inverted yield curve implying roughly even odds of a recession within the next 18 months, it may surprise you that a portfolio of non-traditional ABS and CMBS can be a fixed income investor’s best refuge (outside of long Treasuries) against a severe U.S. downturn. In this Quarterly Strategy Update, we document the historical steadiness of ABS returns through the six most recent recession alarms, from 1998 to the present. We show that the ABS sector experienced basically zero credit losses through the toughest economic stretch in modern times, the Financial Crisis of 2008. This striking performance is due to the high collateral quality and structural protections of ABS securities, which have only strengthened since the Crisis.
We also discuss several of our purchases in the first quarter. These deals, many from new ABS issuers, exemplify the continuing expansion of the Strategy’s opportunity set. We also remark on ABS and CMBS issuance, as well as credit spreads (tighter). We continue to find value across most subsectors of the non-traditional ABS market, and selectively in primary and secondary purchases in CMBS (in particular property types, such as retail, with limited investor focus or exaggerated concerns).
ABS are a safe harbor when recession looms
Economists aren’t known for being great forecasters of recessions. The slope of the yield curve, on the other hand, has a better record – the yield curve has inverted before every recession since 1970. So when the yield on 10-year Treasury bonds fell below 3-month bills (10Y-3M) on March 22nd – for the first time since 2007 – many feared a U.S. recession beckoning.
When investors expect a future economic downturn, they also anticipate that the Fed will ease short-term interest rates in response. This can invert the yield curve. As seen in the chart on the right, since 1970 all but one significant inversion of the 10Y–3M spread was followed shortly by a recession – taking 10 months on average. Given this strong relationship, it is reasonable to assess the likelihood of a recession within one year. The chart on the following page shows this to be 36% as of March 31.5 Some skepticism is in order. The global central banks’ quantitative easing programs have prompted tremendous overseas inflows into U.S. fixed income, which in turn creates purely technical pressures on the shape of the yield curve. Nevertheless, investors should be leery of the impact of a near-term recession on their portfolios.
Unsurprisingly, the potential approach of a recession tends to batter risk assets. Lower economic activity and higher unemployment diminish corporate earnings, reduce confidence, and pressure corporate and consumer credit. U.S. stocks, for example, experienced a bear market before the last seven U.S. recessions. The S&P 500 Index fell 5% on average in the 6 months prior to each.
Most credit bonds are similarly hit by recession fears. The chart below shows the maximum drawdown in returns for the Bloomberg Barclays Investment Grade (IG) Credit and High Yield (HY) bond indices prior to the 2001 recession, and for three “alarms” associated with higher recession likelihoods in 2011, 2015, and 2018. (We discuss 2008 below.) On average, IG credit and HY credit underperformed U.S. Treasuries by 3.7% and 11%, respectively, as market anticipation of a downturn grew.6
ABS returns, interestingly, have been largely insulated from these recession-related drawdowns. Referencing the same figure above, the Bloomberg Barclays ABS index experienced small or no return drawdowns that averaged just -0.2%. Subordinate ABS tranches, with an initial rating below AAA, actually outperformed Treasuries by 0.1% during these periods. Short spread durations and low spread volatility support ABS return stability through all parts of the cycle, including periods of macroeconomic distress.
ABS are also a good shelter for recession because of their demonstrated credit strength through economic adversity. Historically, ABS bonds have exhibited high ratings stability and low losses during even the most severe economic downturn. The Financial Crisis of 2008, the worst U.S. downturn since the Great Depression, surely offers a useful test. Drawing on rating agency data, we can track the cumulative impairment rate of different credit sectors through and following the Crisis (see table above). When we look at all of the investment-grade ABS outstanding at the end of 2007, about $800 billion of debt, and simply follow the bonds’ performance forward through the Crisis and to the present, what we see is that only one ABS security experienced any impairment, which translates into an extremely low rate of 0.02%. In contrast, comparable impairment rates for the IG Corporates and HY Corporate bonds outstanding in 2007 have been 1.5% and 21.1%, respectively.
At the market’s nadir in late 2008, ABS and IG corporates experienced fleeting price declines of about 10 points (High Yield declined over 30%). Clearly though, the exemplary credit performance of ABS helped dampen their price volatility then and continued to do so over the decade since.
Why are the impairment rates for ABS through the Crisis starkly lower than other credit sectors? For one, ABS are explicitly designed to withstand very severe recessions. The first transactions were structured in the mid-1980s. The brutal Reagan-era recession diminished access to unsecured financing as an option for many companies. ABS were introduced as an alternative to help them raise secured financing against their asset portfolios. Standard and Poor’s, for example, continues to this day to set the required equity and subordination cushions beneath ABS debt expressly to assure “securities rated ‘AAA’ should be able to withstand an extreme economic stress without defaulting. The Great Depression, during which unemployment peaked at 24.9% in 1933, is a historical example.”7
The cushions beneath ABS debt have thus always been sized conservatively to withstand the loan or lease pool losses accompanying the most severe recession. These resulting credit enhancement levels are truly prodigious, ranging from 10% to 50% across ABS subsectors (see chart below). Despite ABS’ strong credit performance through the Crisis, credit enhancement levels for ABS have nevertheless risen since the Crisis in tandem with a general tightening of credit criteria by the rating agencies. As an example, you can see in the figure below the lift in enhancement from pre-Crisis levels for prime auto and credit card (in red) to current, higher levels (blue). Further, while credit support levels for ABS at issue are hefty, ABS tend to delever and quickly build further credit support as bonds season. It is common, for example, for subordinate tranches to experience upgrades in as a little as one or two years after issue. This deleveraging also explains the high ratio of ratings upgrades to downgrades in the ABS sector, roughly 10 to 1. (By contrast, this ratio is currently 0.5 for corporate bonds.) Finally, ABS deals include structural performance triggers that can further accelerate the pace of deleveraging if trust performance measures (such as delinquencies, losses, or debt service coverage ratios) lag expectations.
First quarter offers ample opportunities in ABS issuance, selective value in CMBS in secondary
BBH continues to find considerable value across most segments of the ABS market and in certain pockets of the CMBS market. We made substantial additions this quarter across accounts. First quarter ABS and CMBS purchases totaled about $1 billion.
Unlike the Corporate sector, the ABS sector experienced relatively little price turbulence in the fourth quarter, and a correspondingly modest recovery in the first quarter. The window to take advantage of fall spread widening was brief, but we were able to add a few positions in the secondary market. Some of these positions tightened as much as 100 bps by quarter’s end. We also capitalized on wider spreads and participated in several attractive new issue purchases.
Stack Infrastructure issued its first ABS transaction, secured by the company’s geographically diversified real estate portfolio of data centers. The collateral securing the transaction consists of the bulk of Stack’s holdings, 6 of 8 data centers located in the country’s largest data markets, including Northern Virginia, Silicon Valley, Dallas-Fort Worth, and Chicago. In February we participated in the 5-year senior tranche, rated single-A, at a yield of 4.6%.
Finch Investment Group issued its first tax lien ABS securitization in March. The initial collateral for the transaction consists of over 62,000 property tax lien certificates in five states. Finch was formed in 2005 and has purchased and managed over 300,000 tax liens with a total redemptive value of $700 million. The portfolio has a very conservative average ratio of lien size to home value of only 5%. The senior notes are well protected from elevated losses on the tax lien collateral by 12% credit support and 2% annual excess interest spread. Given the negligible losses sustained by tax liens historically, there is minimal credit risk in a securitization; rather the risk would be of a moderate lengthening of the transaction. The notes can in fact bear a multiple of more than 10x over a base loss rate of 1% without impairment. The notes came at attractive levels, with the 2-year AAA-rated and single-A rated notes priced at spreads of 144 bps and 184 bps over Treasuries, respectively.
Hercules Financial issued its fourth ABS securitization. Hercules is a business development corporation (BDC) lender that was founded in 2003 and is listed on the NYSE. The firm specializes in lending to late-stage life sciences and tech firms, and it has a very low historical loss rate on its low loan-to-value (LTV) loan portfolio. Hercules did experience some unwelcome news as founder and CEO Manuel Henriquez stepped down in March after being implicated in the college admissions bribery scandal. Hercules, however, has a deep investment bench and long-standing CIO Scott Bluestein quickly stepped into the chief executive role. The bonds have been unaffected by the shuffle. In January, the 3.4-year single-A rated senior tranche came at an attractive 4.75% yield.
America Car Center (ACC), founded in 2000, brought its inaugural ABS transaction last April. The company has a unique business model, underwriting automobile leases rather than loans, for the purchase of low-mileage used vehicles and has been consistently profitable over its history. The single-A rated senior tranche of ACC’s short 1.6-year ACC’s credit performance was issued in February at 126 bps spread over Treasuries.
BBH also participated in 25 other ABS transactions in the first quarter, including other venture debt ABS senior issuance at 200 bps spread over Treasuries, senior personal consumer loan ABS at spreads over 100 bps over Treasuries, and rental fleet ABS at the mid-100 spreads, as well as range of other attractively priced auto, equipment, credit card, and servicer advance ABS.
In CMBS, the secondary market offered several extremely attractive purchase opportunities. We purchased the BBB-rated tranches of two seasoned 2014 and 2015 CMBS conduit transactions at 6.6% and 7.5% yields, respectively.
We continue to find considerable value in the Hudson’s Bay single-borrower CMBS transaction. It is collateralized by 24 Lord & Taylor and 10 Saks Fifth Avenue stores located in 15 states, either freestanding or attached to leading regional malls. Hudson’s Bay Company and Simon Property Group are joint sponsors. In March, we bought the 5.4-year AA-rated tranche of the deal at a spread of 275 bps over Treasuries.
One very short but attractive purchase this quarter was GSMS 2014-GSFL. This was a 2014 multi-borrower floating rate transaction originally secured by a pool of eight mortgage loans over 59 separate properties. However, by the time of our January purchase, the deal had deleveraged considerably, with only a Rite Aid portfolio loan and one small industrial loan remaining. At this time, both loans have matured and paid off, earning us a return yield of over 6% for the short holding period.
We did participate in one notable new issue in March, a floating rate, single-borrower transaction. RETL 2019-RVP is a $900 million floating rate two-year loan collateralized by 25 retail properties spread across 14 U.S. states. The portfolio is 91% leased by over 400 unique tenants with anchors including national retailers such as Walmart, Target, and Costco. The borrower’s sponsor is publicly traded REIT Retail Value Inc. We participated in the AAA-rated and AA-rated tranches of the transaction at 1-month LIBOR plus 115 bps and 155 bps, respectively.
Non-traditional issuers drive heavy ABS supply, while CMBS issuance slows in Q1
After record post-Crisis issuance of $229 billion in 2018, ABS issuance was off to a strong start in 2019, with $59 billion in the first quarter (see chart below). Similar to the pattern of recent years, issuance was driven primarily by the diversity of subsectors outside prime auto and credit card ABS.
In the first quarter, we had the opportunity to meet with more than 20 potential new issuers. It is clear that the ABS market is drawing a widening spectrum of industries and a continuous inflow of new issuers. This is a healthy development for the sector. As this range of subsectors within the ABS market expands, the market’s reliance on prime auto and credit card subsectors continues to decline. In the first quarter, for instance, ABS deals emerged across 22 different subsectors (see table below). Prime auto and cards accounted for only 27% of that volume. Based on the number of deals, other subsectors were even more dominant – 60 out of 81 transactions and 57 out of 77 issuers. Since the Crisis of 2008, U.S. finance companies have increasingly relied on ABS, and the capital markets, to diversify their funding away from banks.
Turning to CMBS, the pace of new issuance, $21 billion in the first quarter, trailed the prior year’s volume by 11%. The drop is partly attributable to the inauspicious 10th anniversary of the CMBS market disruption in early 2009. A dearth of 2009 issuance means few 10-year securitized loans are maturing in 2019, which limits refinancing flows into new CMBS pools. The forecast for all of 2019 is for $90 billion, with non-traditional single-asset, single-borrower (SASB) and commercial real estate collateralized loan obligation (CRE CLO) segments growing further in prominence.
Despite lower volume, private label net issuance (as shown in the chart on the following page) grew by $5 billion. This continues the 2018 theme of an expanding CMBS market – last year the outstanding CMBS market grew by $32 billion. We expect the market to grow similarly in 2019, closing in on the $500 billion mark.
ABS and CMBS spreads tighten in Q1
Like the broader credit markets, we have seen a majority of subsectors in ABS and CMBS retrace most of the spread widening that occurred in the Q4 2018. We saw the most widening in CMBS conduit BBBs during the fourth quarter so it was not surprising to see the biggest tightening in spreads in this segment of the market, where spreads narrowed over 100 bps. As show below, current spread levels for most ABS and CMBS subsectors continue to offer substantially greater compensation that comparably-rated Corporate bonds, prime auto, and credit card ABS.
While the U.S. economy continues to generate moderate growth and recession may not be likely anyime soon, an inverted yield curve should serve to focus investors on their credit positioning as the end of this cycle grows nearer. ABS have historically offered a safe refuge through recession. ABS exhibit strong credit performance through recessions – through 2008 the cumulative impairment rates to investors on all outstanding investment grade ABS was just 0.02%. This price and credit stability is understandable given that ABS were originally designed to withstand the most severe recession. Large 10% to 50% credit support cushions ABS debt, they can de-lever quickly to build further credit support, and they have protective structural triggers that accelerate deleveraging in the event that performance lags expectations.
With the yield curve inverted, we see little value for investors in extending duration in their portfolios. We very much like the combination of durable credit protection and high compensation offered by the ABS and CMBS sectors – especially versus Corporates – and these investments play a prominent role across our managed portfolios.
Neil Hohmann, PhD
Head of Structured Fixed Income and Portfolio Co-Manager
Andrew P. Hofer
Head of Taxable Fixed Income and Portfolio Co-Manager
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Mortgage-backed and asset-backed securities have prepayment and extension risks.
Single-Asset, Single-Borrower (SASB) lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple commercial properties.
The Structured Fixed Income Strategy Representative Account is a single representative account that invests in the Structured Fixed Income strategy. It is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the proposed investment strategy.
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IM-06346-2019-04-26 Exp Date 07/31/2019
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.
2 Traditional ABS includes prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS includes ABS backed by other collateral types.
3 Strategy returns reported gross of fees.
4 A measure of volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
5 BBH estimates the probability that a recession will begin within 12 months, based on historical data from 1970 to the present for the10Y-3M Treasury yield spread, the Chicago Fed National Activity Index, and the NBER.
6 Declining interest rates helped cushion absolute return drawdowns in credit during each of these episodes. However, with 10-year Treasury yields near historical lows, there is currently less capacity for long Treasury yield declines to offset wider spreads in U.S. credit.
7 Standard and Poors, “Global Methodology and Assumptions For Assessing The Credit Quality Of Securitized Consumer Receivables,” 2017.