Where Banks Steps Away, Securitization Steps In… Resulting in Abundant Supply and Value for Investors

In the fourth quarter of 2019, some positive news poked through a gloomy U.S. macroeconomic outlook. A firmer labor market, an expanding service sector, and robust retail sales remain cornerstones to solid U.S. economic growth. Weakness persists elsewhere, though. Consumer confidence waned, manufacturing continued to contract, and corporate earnings declined for a third straight quarter. Overseas, European manufacturing declined and Chinese growth slowed. The U.S. and China signed a phase-one trade deal, but the protests in Hong Kong and the coronavirus fed further uncertainty.

With mixed conditions, the Federal Reserve took a pause after its third rate cut of 2019 in October. With the better economic outlook, the U.S. Treasury yield curve steepened, with 10-year yields up 24 basis points1 (bps), 2-year yields down 5 bps, and 3-month T-Bill yields down 33 bps.

The steepening U.S. yield curve threw more fuel on the fire of foreign investment in U.S. Treasuries and corporates. A lower Fed Funds rate reduces the hedging costs that European and Asian investors bear to invest across currencies, while the higher yields further out the curve make U.S. bonds more attractive. At year-end, investment grade and high yield corporate bond spreads hovered near their 2019 and long-term historical lows, despite a decidedly mixed U.S. and global economic outlook.

Investors in U.S. corporate credit today face daunting competition: central bank bond purchase programs, massive cross-over demand from foreign buyers, and shrinking corporate supply. Given the depressed compensation generally available across corporate credit, U.S. investors have been searching for value in other parts of the fixed income market that are better insulated from foreign demand. A common choice is structured credit.

Yield Curve Steepened in Q4 Chart

Option-Adjusted Spreads Chart

In contrast to the challenging technicals faced by corporate investors, investors in many segments of structured credit find more favorable technical conditions. For example, we’ve explored in the past how foreign ownership is generally absent from asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), helping to maintain healthier spread levels and reduce return volatility. Below we explore another powerful driver of value for securitized investors – the swiftly climbing supply of structured credit. Independent finance companies have stepped up their lending as U.S. banks retreat, and are issuing more ABS to finance it. For instance, ABS issuance (outside of credit cards) has jumped as non-bank lenders grow and increasingly finance themselves through securitization. Meanwhile, direct lenders to U.S. middle market companies are also displacing the banks. They issue debt in financing vehicles such as business development companies (BDCs) to fund their growth. Finally, the collateralized loan obligation (CLO) market has doubled in size as banks are retaining fewer of the loans they syndicate. All in all, this growth in supply, coupled with a stable domestic buyer base, helps keep structured credit spreads healthy even as corporate spreads bottom out.

Exploiting these friendly technicals across structured credit sectors can command a substantial spread advantage within a portfolio. One example is BBH’s Structured Strategy (the “Strategy”), an investment-grade portfolio of bonds constructed from a wide range of over 20 ABS and CMBS subsectors, which currently yields 4.2%2. This represents a 250 bps spread over Treasuries, a sizable lift over high-quality credit alternatives. The representative account of the Strategy has a short rate duration exposure of 2.0 years and a spread duration of only 2.6 years. Historic three-year returns for the Strategy are 5.5% (6.1% in 2017, 4.4% in 2018, 6.1% in 2019), with a notably low 0.9% annualized return volatility. The Strategy returned 0.85% last quarter. Liquidity is good, between 10 and 30 bps on a bid/ask spread basis, and 86% of the portfolio is rated investment grade. The correlation to the broader credit market is low – the 6-month rolling beta of the Strategy to the Bloomberg Barclays U.S. Credit Index is less than 0.3.

A Portfolio of Diversified High-Quality ABS and CMBS Offers a Substantial Yield Advantage with Short Rate and Spread Durations

The higher compensation on offer for most ABS and CMBS subsectors results from the persistence of these favorable factors: steadily rising bond supply from an expanding non-bank lending market and a limited, stable investor base of domestic institutional buyers that know these products. As we show below, we expect these features to continue to hold for ABS and CMBS investors in 2020.

Heavy Q4 issuance offers opportunities in ABS and CMBS

New ABS and CMBS supply were particularly heavy in the fourth quarter: $54 billion and $35 billion, respectively. CMBS supply in particular set a post-crisis quarterly record (see CMBS supply figure below) as sharply declining U.S. interest rates in 2019 motivated commercial property owners to refinance. Annual ABS supply continued its steady climb due to the growth of non-bank lenders and their desire to finance themselves through securitization. The share of non-traditional asset types (i.e. excluding prime auto and credit cards) within all ABS issuance escalates every year, rising from 62% in 2018 to 69% in 2019. The dominance of non-traditional3 ABS is even more evident in the number of their issuers – 170 out of 203 total in 2019 (see Appendix for additional exhibits).

New CMBS Supply Shot Up in Q4 in Response to 2019’s Rate Declines

Heavy supply supports healthy spread levels in ABS and CMBS. Spreads in ABS and CMBS lagged the performance of corporates on the quarter partly driven by the widening of swap spreads, which is the benchmark pricing convention for ABS and CMBS bonds. However, the ABS and CMBS market was still able to end the year on a very strong note with most sectors about 10 bps to 30 bps tighter on the year and subordinate CMBS tranches tightening even more (north of a 100 bps tighter).

BBH continues to find value across most subsectors of the non-traditional ABS market, in short tenor CLOs, and selectively in primary and secondary purchases in CMBS (in particular property types, such as retail, with limited investor focus or exaggerated concerns). These deals, many from new ABS issuers, exemplify the continuing expansion of the Strategy’s opportunity set. Attractive fourth quarter purchases are outlined below. Across accounts, we made substantial additions in the fourth quarter. Over 2019, our ABS and CMBS purchases totaled just over $4 billion.

ReadyCap Lending is one of the few independently licensed Small Business Administration (SBA) lenders. ReadyCap originates and services small business loans guaranteed by the SBA for acquiring real estate and equipment, or for working capital purposes. The company has an established 10-year track lending track record. In December, ReadyCap issued its second securitization secured by a 6-year seasoned pool of loans with strong structural protections. The 4-year notes were rated BBB- and came at an attractive spread over U.S. Treasuries of 250 bps.

Another ABS addition in the quarter came from Republic Finance. This 70-year old personal consumer lender in the southeastern U.S. is a “brick-and-mortar” independent lender that serves below-prime credit borrowers. The company brought to market its first securitization of consumer loans originated in its branch offices. The notes possess strong structural protections in the forms of overcollateralization and substantial excess cash flows that insulate our investments. We purchased the 2.5-year A-rated bonds of this first-time issuer at a spread of 188 bps over U.S. Treasuries.

North American Development Group (NADG) issued its first triple-net ABS transaction in November from its public real estate investment trust (REIT) (NNN). The notes are backed by a pool of 136 free-standing outparcels, located in the front of shopping centers with prime visibility and access to vehicle traffic. The properties are on triple-net leases to high-quality U.S. bank and retail companies, with an average 10 years remaining on lease. NADG, founded in 1977, has long experience managing this property type which it views as superior to anchored retail. We participated in the single-A rated 2.5-year senior notes at a spread of 185 bps over U.S. Treasuries.

In October, Pawnee Leasing Corporation issued its first small-ticket equipment ABS, secured by a highly diversified pool across customer, industries, and geography. Headquartered in Fort Collins, CO, Pawnee has been leasing to U.S. companies for 37 years, with solid profitability and stable operating margins over that period. The company is wholly owned by its public parent company Chesswood, of which Pawnee makes up 85% of revenue. The notes are well-enhanced with a substantial Pawnee equity position beneath them. Pool diversification and structural features provide ample protection for our investment. We participated in the AAA-rated 2-year senior notes at 91 bps over U.S. Treasuries.

Over the quarter we also took advantage of heavy CMBS supply to participate in two attractive single-asset, single-borrower (SASB) transactions. MBRT 2019-MBR is secured by a $515 million commercial mortgage loan on the Monarch Bay Club, a Five Diamond-rated luxury full-service resort that sits along the coastline in Dana Point, CA. Capital improvements of $56 million have been undertaken since 2014, with a further $20 million planned for investment. Our baseline loan-to-value (LTV) ratio estimate for the AAA-rated senior notes is a remarkably low 27%. Even our fully stressed valuation implies an LTV of only 37%. We participated in this very low leverage, senior AAA-rated 2-year notes in December at 1-month London Interbank Offered Rate (1mL) + 110 bps.
In October, the Blackstone Group issued an SASB transaction BX 2019-XL backed by an enormous $5.6 billion mortgage loan on 406 industrial properties (65.7 million square feet) located across 18 states. Industrial warehouse properties have experienced rapid demand growth coincident with the rise in online retail. Current occupancy across the property pool is 95%. Our baseline LTV estimate for the AAA-rated senior notes is a modest 35%, and stressed LTV is a low 47%. We found the senior notes to be the most attractively valued in the transaction and purchased the 2-year notes at 1mL+92bps.

Non-bank finance companies step into many lending segments, leading ABS, CMBS, and CLO supply to double over the last decade

Domestic investors face daunting competition in most credit sectors from foreign flows. Yet there is one trend in fixed income that is producing more favorable technicals for value-seeking credit investors – the disintermediation of banks from commercial and consumer lending and their replacement with non-bank, independent finance companies. Over the past 40 years, bank lending as a proportion of total U.S. private debt has declined from 50% to 30%, driven by the rise of loan securitization, the growing sophistication of capital markets, and changes in bank accounting and regulatory standards (the teal line in the chart at the top of the next page). Since the Financial Crisis, the bank share of total debt may appear to have stabilized near 30% overall, but this is only because of the disappearance of the $2.5 trillion private residential mortgage-backed securities (RMBS) market after the Crisis. If you exclude residential mortgages, the banks’ share of total U.S. private debt has declined by about 5% since 2007 (illustrated by the gray line in the chart). This represents a $750 billion gap, filled by non-bank lenders.

Stricter capital and liquidity rules, along with borrower leverage limits, are partly responsible for the banks’ declining role post-Crisis. Banks have ceded share in particular on higher yield, high leverage commercial loans. CLOs have boomed as a sector over the last decade as the primary holder of bank-syndicated leveraged loans (see chart below.) U.S. banks’ share of ownership of these loans has dropped from 15% to 5%.

High-yield commercial debt that is directly originated by independent lenders (“direct” or “middle market” loans) has grown even more quickly, from $270 billion in 2009 to $780 billion in 2018. These loans tend to be held in private funds or by BDCs, which have emerged as a new sector of the corporate bond market, less familiar to large and index investors.

As they grow, non-bank financial companies have also increasingly turned to the ABS and CMBS markets to diversify their own financing sources, resulting in an acceleration of new supply in these bond sectors over the last decade. “Non-traditional” asset types, such as equipment finance, personal consumer loans, and small business lending in ABS, and large single-borrower loans in CMBS, have more than doubled in size over the last decade (see chart below).

Bank Share of U.S. Private Debt Has Declined Since the 1980s, and ex-RMBS Since 2008

Non-Bank Lending Growth Has Led to Hundreds of Billions in New Securitization Supply

Conclusions

Credit investors are less familiar with these growing fixed income segments – non-traditional ABS and CMBS, CLOs, and BDCs. A dozen or two investors may participate in an issue, rather than hundreds as in most corporate debt and traditional ABS. Deal sizes, $500 million or less, are often too small to be meaningful to large fund managers. The limited investor awareness coupled with heavy new supply maintains a healthy technical for investors. Spreads over U.S. Treasuries available in these sectors are typically 75 bps to 300 bps higher than similarly-rated credits in the broad credit indices. As a medium-sized asset manager with long experience in structured products and these non-bank finance sectors, BBH has been well-positioned to take advantage of opportunities in all of these segments.
Sincerely,


Neil Hohmann, PhD
Head of Structured Fixed Income and Portfolio Co-Manager
   

Andrew P. Hofer
Head of Taxable Fixed Income and Portfolio Co-Manager

Appendix

Exhibit I: ABS and CMBS Spreads

Exhibit II: ABS Issuance

ABS Issuance

Performance As of December 31, 2019

Definition
Aaa Corporate, Aa Corporate, A Corporate, Baa Corporate, U.S. Corporate Investment Grade, U.S. Mortgage Backed Securities, Non-Agency Investment Grade CMBS: Eligible for U.S. Aggregate, Asset-Backed Securities, ABS Credit Card, ABS Auto, U.S. Corporate High Yield, and EM USD Aggregate are components of the Bloomberg Barclays U.S. Aggregate Index.

Risks

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.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved.
Not FDIC Insured No Bank Guarantee May Lose Money IM-07558-2020-02-06 Exp. Date 04/30/2020

1A unit that is equal to 1/100th of 1% and is to denote the change in price or yield of a financial instrument.
2Strategy returns reported gross of fees.
3 Traditional ABS includes prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS includes ABS backed by other collateral types.