Supply and Demand Technicals Weigh on Longer ABS and CMBS Notes

Credit Markets with Macroeconomic Sentiment in First Quarter

Credit market weakness continued into January and February, before a sharp recovery in March (which continues in April). Early weakness stemmed from familiar causes: macroeconomic concerns, mutual fund outflows, a flight-to-quality rally in U.S. Treasuries, and lower equity and commodity prices. Weak U.S. economic indicators were a particular concern – according to JP Morgan, the implied likelihood of a near-term recession rose as high as 23% in mid-February. Cautious dealers and lower trading volumes exacerbated selling pressures.

In March, however, credit investors were reassured by a strong February employment report and improving consumer sentiment. Also, on March 7th the Chinese premier pledged expanded lending to support economic growth near 7%, which in turn boosted oil and steel prices. JP Morgan’s implied recession probability dropped to 13%. By quarter-end, Corporate credit had mostly retraced its earlier declines.

Supply and Demand Technicals Drive Differentials in ABS Performance, While Fundamentals Remain Strong

Asset-backed securities (ABS) continued to perform to different patterns than broader credit markets. Over the 18 months ending in December 2015, broader credit markets turned in their worst performance since the Financial Crisis. During this period, for example, triple-B rated and High Yield Corporates underperformed their U.S. Treasury benchmarks by 4% and 6.7%, respectively, in the Barclays Indices. In contrast, ABS and commercial mortgage-backed securities (CMBS) have generally posted positive, stable returns – a placid 0.5% and -0.3%, respectively, relative to U.S. Treasuries over the same turbulent period. We remarked in last quarter’s Strategy Update that the estimated beta of non-traditional ABS returns relative to the Barclays Credit Index is accordingly quite low.

In January and February, certain non-traditional ABS subsectors underperformed, particularly those with longer tenors. Prices for more traditional ABS products, on the other hand, remained firm. For example, five-year container and aircraft ABS widened 180 basis points (bps) and 40 bps on the quarter, respectively. Two-year single-A rated subprime auto widened 30 bps, while three-year prime auto and credit card ABS widened less than 10 bps.

It is tempting to attribute the disparities in ABS performance this quarter to the market’s short-lived recession fears. The great diversity of non-traditional ABS subsectors (more than 30 at last count) may shield ABS sector returns from distress in any single industry, such as energy. But just like Corporates, many ABS products are exposed to U.S. macro-economic trends, and a U.S. economic downturn would surely affect many ABS issuers.

The recession explanation is incomplete. ABS credit fundamentals remain strong – delinquency and loss rates across ABS collateral types range between historical lows and normal levels. And it’s hard to square the disproportionate underperformance of aviation ABS with their strong fundamentals related to low fuel prices.

We therefore attribute the disparity in spread moves more to a combination of recession fears and specific supply and demand technicals in ABS markets than to fundamental concerns. ABS investors and dealers were cautious putting money to work in the first two months of the year. Dealers were particularly reticent to hold longer duration positions, owing to greater price volatility. They instead favored more-established issuers and shorter notes. Lighter demand was also reflected in lower trading volumes.

The Quarter Offered Attractive Opportunities in Personal Consumer Loan ABS

We added two attractive personal consumer loan ABS purchases in the first quarter. Lendmark has conservatively underwritten consumer installment loans for over 20 years, first as a subsidiary of BB&T bank and currently as a standalone lender, and have been profitable every year. Over this time, they have been profitable every year. We participated in Lendmark’s first ever 2.5 year ABS transaction in February at an attractive spread of T+400 bps, rated double-A by DBRS.

Similarly, consumer lender Avant’s management team has originated consumer loans since 2002 and retains equity in their loans. We participated in the short 0.5 year senior notes of their single-A rated second securitization transaction in February at a spread of T+375 bps.

Subprime Auto ABS in the Headlines: As Usual, Some Smoke, But No Fire.

In March, The Wall Street Journal published a front-page article on the subprime auto industry, citing a Fitch report that delinquency rates are at   20-year highs. In the case of the subprime auto sector, losses tend to spike up in the first quarter, as borrowers get overextended through the holidays. This has happened each of the last four years, and each time it has prompted overwrought press concerns about a bubble. Furthermore, the Fitch numbers are highly biased by compositional effects and are generally misrepresentative from our perspective.

Loss rates for subprime auto loans are in fact still well within historical norms (see chart to the right) and run below the baseline level we project for this class of collateral. Current loss rates are far below the much higher levels at which we stress-test our purchases. Meanwhile, our existing ABS holdings, with an average life of about one year, build credit enhancement as they season, becoming less vulnerable to any downturn with aging. Our latest collateral run puts the average of our entire subprime auto ABS credit support at 43%, meaning that transactions can absorb defaults of well over half of the remaining loans before our position takes any loss.

We invest only in the most well-established and experienced issuers of subprime auto ABS (such as GM Financial, Santander, and Credit Acceptance), and continue to find value in these strong credits.

SASB CMBS Spreads Widen Modestly

A large majority of our CMBS holdings are single-asset, single-borrower (SASB) transactions that are secured by the senior mortgage loan on a single trophy property or a high-quality portfolio of properties. Based on our stringent credit criteria, we participate only at a very low leverage point of between 25% and 40% loan-to-value (LTV) and only in transactions where the owner and borrower is a large, highly-experienced sponsor. Historical credit performance for SASB transactions is exemplary – no investment grade note has ever experienced a loss – and the notes tend have shorter two to seven year tenors.

For all of these reasons, SASB CMBS return volatility is subdued relative to conduit (or multi-property) CMBS. This remained so in a turbulent first quarter. Spreads for a typical SASB transaction widened modestly, by 30 bps for triple-B and single-A rated deals and by 20 bps for higher rated tranches. SASB transactions offer an even more attractive value proposition at these spreads and we continue to add judiciously.

BBH CMBS Specialist Vaidas Nutautas and I recently authored a report on this growing segment of the CMBS market (“Rise of the Single-Asset, Single-Borrower Market”, March 2016), which we invite you to download from our website.

New Issue Conduit CMBS Spreads Swing in Tandem with Corporates

Ten-year new issue conduit CMBS, on the other hand, exhibited large swings in pricing in the first quarter, even as commercial real estate fundamentals remain firm. We have only a small (<5%) exposure to new issue conduit in the strategy. In our experience, volatile 10-year conduit performance is closely tied to demand and supply factors that have been particularly dynamic over the past several months.

Corporate and ABS issuers generally have significant discretion over the timing of their new debt issuance. In contrast, conduit CMBS issuers warehouse loans in advance of a transaction and must securitize their limited warehouse capacity with regularity in order to continue originating new loans. Investor demand for new conduit issuance naturally ebbs and flows with investor appetite and perceived credit. Unsurprisingly, and more so than in other credit markets, the conduit market experiences frequent episodes where unavoidable spikes in supply coincide with periods of weaker demand conditions, and spreads widen to compensate. Supposing the inventory of CMBS held by dealers to be a rough proxy of market demand appetite, the graph below shows, that episodes of substantial credit widening in triple-A rated new issue conduit CMBS over the last year accompany periods where new issue supply is high relative to demand.

Not only is the conduit CMBS market subject to these unavoidable bouts of supply, but the level of demand for 10-year conduit CMBS is also closely tied to crossover interest from corporate bond investors. When spread compensation for corporate credit rises, for example, conduit CMBS must offer higher spreads to maintain demand. Conduit CMBS spreads therefore track much more closely to corporate spread trends than do SASB CMBS and ABS. This is readily apparent in the graphs below, as patterns of spreads at both the top (triple-A) and bottom (triple-B-) of the conduit capital structure closely match Corporate proxies.

Finally, we have not observed that credit fundamentals have much to do with these spread movements. Most of the properties in our portfolios are reporting increases in releasing revenues, malls are reporting higher foot traffic and rents, and hotels and office buildings are at high-levels of occupancy. Underlying credit indicators continue to improve. Credit and rating discipline, while looser than 2010, remains strict relative to the pre-crisis era.

Given these more volatile technicals and the higher correlation to credit markets, we require greater spread compensation to hold new issue 10-year conduit CMBS based on our valuation framework. This helps explain our smaller holdings. Nonetheless, we expect continuing investor caution, lower dealer inventories, and bouts of new supply to provide future opportunities to participate in conduit.

Conclusion

Demand for non-traditional ABS and CMBS products has strengthened even further into early April, which should bolster performance and the pace of new issuance. Nonetheless, we are still seeing extraordinary opportunities in both primary and secondary markets, particularly in the longer-tenor Equipment and Commercial Real Estate sub-sectors that were softer in January and February. Given the continuing firmness of credit fundamentals, we think now is a particularly good near-term entry point for many ABS and CMBS products.

Sincerely,

Andrew P. Hofer
Portfolio Co-Manager

Neil Hohmann, PhD
Portfolio Co-Manager