Better In the U.S.

U.S. ABS and CMBS Markets Strengthened Through Second Quarter

U.S. Asset-Backed Securities (ABS) spreads continued to march tighter over the second quarter, continuing a recovery from the recession fears over U.S., Europe, and Asia that dogged credit markets earlier this year. U.S. monthly new job growth averaged roughly 150,000 this quarter, below the 200,000 average pace of 2015, but still strong enough to buoy moderate economic growth. Consumer spending and housing activity is strong, and leading indicators are also positive. U.S. Corporate  profits remain durable, contributing to a broad rally in credit. Strength in the job market and economy continue to support U.S. ABS fundamentals.

U.S. interest rates fell to historical lows (the 10-year U.S. Treasury yield was 1.47% at quarter-end). The primary driver has been large inflows into dollar assets that reflect the growth challenges and monetary stimuli in Europe and Japan, rather than concerns over the U.S. economy. Lower rates are generally positive for structured credit fundamentals, buoying commercial real estate valuations and lowering consumer debt burdens, but they also cut into net interest margins for some lenders.

The chart below shows that spreads broadly tightened across corporate, ABS, and CMBS markets in the second quarter. Within investment grade corporate bonds, triple-B rated credit in the Barclays Capital index tightened 17 basis points (bps) on the quarter, mostly the result of a sharp rallies in the energy and materials sectors. In ABS markets, traditional triple-A rated prime auto ABS and credit card ABS tightened 12 bps on the quarter.

Non-traditional ABS rebounded more sharply, with triple-A rated rental fleet and tax lien ABS 44 bps and 25 bps tighter, respectively. Shorter single-A rated ABS sub-sectors rallied similarly, with consumer loan ABS tighter on the quarter by 80 bps.

Longer duration ABS sub-sectors such as aircraft, container, and net lease ABS tend to trade more on yield than spread, and so they remained flat or tightened moderately given the sharp U.S. Treasury rate rally in second quarter.

Similarly, shorter life single-asset Commercial Mortgage-Backed Securities (CMBS) benefited technically from strong investor demand and fundamentally from lower U.S. rates. Broadly, Investment Grade Single-Asset CMBS tightened between 20 bps to 80 bps across the capital stack. Conduit CMBS, which trade more in tandem with corporate markets, tightened similarly.

Structured Credit Weathered An Unexpected Brexit Well

The United Kingdom (UK) vote in June to exit the European Union came as a shock to financial markets, triggering a sharp depreciation of the pound sterling against the dollar and yen, and a coincident flight to safety rally in U.S. Treasuries. U.S. ABS kept up with this rally quite well, with widening only 0 bps to 10 bps on the day following the vote across the ABS sub-sectors we hold, and gradual recovery over succeeding days.

We hold no pound sterling in the strategy and only a minimum across other mandates – one UK bank credit card trust and a one UK prime auto trust from experienced issuer Santander, both denominated in dollars. Performance on these high quality, short tenor pools is expected to remain very strong. Similarly, there is no Eurozone ABS exposure in the strategy.

Two reasons we tend to avoid Eurozone ABS issuance are the thin market and relatively poor fundamentals. Total issuance of ABS outside the U.S. and denominated in non-dollar currencies is projected to be just $53 billion in 2016, with the UK representing $17 billion and the Eurozone representing only $28 billion. These are very small relative to projected 2016 U.S. issuance of close to $180 billion. Weekly trading volume in Eurozone ABS is only about €170 million, compared to $5 billion for U.S. ABS. Compensation is also meager. Spreads are actually negative for the larger Dutch RMBS and German prime auto sub-sectors, as the European Central Bank (ECB) focuses purchases in these securities as part of its monetary stimulus program.

Where spreads are somewhat higher – in Italian, Spanish, and Portuguese consumer ABS – we have serious concerns about the credit quality and underlying fundamentals in these sub-sectors. Growing balances of bad loans at Italian banks are a warning sign, and we continue to avoid peripheral Eurozone exposures. We are much better compensated for high quality, liquid sub-sectors of the U.S. ABS market.

Single-asset CMBS held in well through Brexit, widening up to 10 bps in tandem with ABS. Conduit CMBS again performed roughly in line with longer corporate credit, with triple-B rated CMBS widening 30 bps on the Brexit news and recovering about half of that through the end of June. The lower rate environment following the Brexit vote has been supportive of commercial real estate fundamentals.

A Productive Quarter for Position Additions

ABS sub-sectors such as prime auto and credit cards are priced too tight to hold our interest. Yet other asset-backed sectors within consumer and commercial finance continue to offer attractive valuations, as rising issuance over the last several years has been absorbed by a relatively stable investor set. Based on rigorous stress-testing, our positions in these securities are extremely well-protected from even severe recession levels of loss.

In the second quarter, we added to three single-A rated notes at a spread over U.S. Treasuries greater than 300 bps. These included ABS notes secured by auto loans from seasoned issuer Credit Acceptance and by senior-secured healthcare loans from veteran issuer Oxford Financial. We also participated in triple-A rated transactions at spreads of 100 bps to 250 bps over U.S. Treasuries that were secured by high-quality truck fleet, servicer advances, and tax lien assets.

A Positive Outlook for the Second Half of 2016

Issuance of ABS in 2016 is projected to come in close to $180 billion, slightly below 2015’s $190 billion level, so moderate supply should not be a problem in the second half of this year. U.S. consumer debt burdens continue to decline, and interest rates remain low, which support solid ABS and CMBS collateral performance, even as the corporate debt sector undergoes re-levering. With their short tenors and a stable investor base, ABS return volatility also remains moderate relative to broader corporate markets, evident once again through the recent 18-month bear cycle in credit markets. Finally, the overwhelmingly U.S. composition of the ABS and CMBS markets helps shelter the sector from bouts of economic weakness in Europe, Asia, and Latin America.

With the 2-year U.S. Treasury yield at 0.6% at quarter-end, the slope of the yield curve relatively flat and the yield of the 1-3 Year Barclays Capital Investment Grade Corporate Index near 1.5%, opportunities within the Corporate sector are limited. A strategy of investing in high-credit quality non-traditional ABS and CMBS, though, where a diversified portfolio can offer yields of 4.5% to 5.5% with a rate duration of less than two years, does seem particularly compelling at this time.

Sincerely,

Andrew P. Hofer
Portfolio Co-Manager

Neil Hohmann, PhD
Portfolio Co-Manager