New Year’s Resolution: Build Up Those ABS

The fourth quarter brought a note of hope to the end of a harrowing 2020. The COVID virus continues to surge across the U.S. Lockdowns have resumed nationwide and are stressing large swathes of the economy. New jobless claims are still four times pre-COVID levels, U.S. employment gains have slowed, and the unemployment rate stubbornly lingers at 6.7%. U.S. economic growth is expected to moderate in the first quarter of 2021, but still remain positive.

Nevertheless, with Food and Drug Administration (FDA) approval and the distribution of successful vaccines, most Americans could be vaccinated within six to nine months, with a semblance of normalcy returning to their lives by fall. With record turnout in the November elections, the U.S. political system sidestepped the worst-case outcomes. The year-end passage of a $900 billion COVID relief bill, with another likely by the end of Q1, offers a bridge for the economy towards a brisk expansion anticipated to pick up in the spring.

Risk assets rallied heavily on these welcome fourth quarter developments. Global and U.S. equity markets pushed to new highs, while investment-grade (IG) and high yield (HY) credit indices plumbed record low yields – even accounting for the quarter point sell off in the U.S. 10-year Treasury yield to 0.9%. The fourth quarter result boosted full-year returns for U.S. IG and HY credit up over the returns for same duration Treasuries, a remarkable recovery given their underperformance earlier in the year (-12.7% and -17% through March in the Bloomberg Barclays U.S. Credit and High Yield indices, respectively). This whipsaw in risk assets last year was spurred by a raft of fiscal, monetary, and direct Federal Reserve (Fed) purchase support, unprecedented in size and speed.

The remarkable developments of 2020 set a new stage for fixed income investors in 2021. We note several key themes.

First, the credit picture is uneven. In sectors of the economy less affected by COVID, demand has recovered to or near pre-COVID levels, but macroeconomic weakness remains evident. The thick liquidity buffers that corporations amassed last year against uncertainty heighten their financial leverage and must be worked down over time. For the COVID-affected sectors (transportation, entertainment, energy, and hospitality), the current COVID wave is another hammer blow to business models, both in the near-term until vaccination relief, but also longer term, as COVID shifts consumption patterns. The chart on the right shows many industries are still painfully distant from full employment. Bond downgrade and default risks, while reduced from March, are still above any other point since the Global Financial Crisis (GFC). Fitch Ratings, for instance, is projecting the 3-year cumulative default rate from 2020 to 2022 for leveraged loans and high-yield bonds to be 15% to 20%, comparable to defaults through the GFC. Investors should be particularly focused on credit fundamentals – spread compensation alone is a faultier indicator of credit strength today than usual.

Second, policy uncertainty remains unusually high. A deadlocked Congress took months to birth even a minimal COVID relief bill. Given the razor-thin margin in the Senate, further tranches of COVID relief in 2021 may be of smaller scale. U.S. budget deficits remain gargantuan, and a record amount of new Treasury issuance must be digested by investors. While many welcome the stability of a Biden administration, a sharply-divided Congress may stifle fiscal response or reform. All these uncertainties heighten market volatility versus the prior state of policy. Even with yields for credit and rates at their floors, investors should further discount compensation for the elevated policy risk.

Third, the level and steepness of the Treasury yield curve are near historic lows. The chart below illustrates that 2-year yields are essentially zero and the yield curve out to 5- and 10-year tenors is extraordinarily flat. The balance of risks is highly asymmetric to rising rates, particularly at medium 2- to 10-year tenors should a U.S. recovery and/or inflation measures surprise to the upside. There is little reward and substantial risk to investors holding any meaningful rate duration – including investors that typically extend asset duration to match liabilities. Short, higher carry holdings are much favored in this environment.

Alas, fourth, the carry available in IG credit is historically low (as it is for rates). A history of credit yields is shown in the chart on the bottom of the previous page. In the Bloomberg Barclays indices, yields today reach only 0.5% for 1- to 3-year IG corporates, 1.8% for the 9-year IG corporate index, and 3.2% for BB-rated bonds in the High Yield Index. Whether viewed at short or longer tenors, one year’s credit compensation cannot offset even a moderate rise in rates or spreads. The chart below shows breakeven rates in the credit market over the last five years (i.e., the rise in yield or spread needed to wipe out a year of carry return). Current return breakevens are at dangerously historic lows. Even a modest sell-off in rates or spreads of around 30 basis points¹ (bps) for IG corporates clears this low bar and cancels a year’s income. (To contrast this with one sector in structured credit, return breakeven rates for non-traditional² asset-backed securities (ABS) in the JP Morgan Other ABS index have remained stable near 100 bps.)

Historic returns confirm the danger of such low breakeven rates for average credits. In the chart on the right, JP Morgan plots annual excess returns for the IG Corporate Index since 2000 against the excess return breakeven spread at which they start the year. In every year where the breakeven for IG credit starts below 18 bps, credit underperformed Treasuries. As of December 31, that excess return breakeven for the Index stands at only 12 bps. Under the circumstances, we are shifting portfolios to shorter and higher carry positions.

Fifth, an extraordinary demand technical explains and perpetuates this challenging compensation picture. The U.S. fixed income market is awash in trillions of dollars of central bank liquidity. The Fed continues to purchase $120 billion of Treasuries and mortgage-backed securities (MBS) each month (and is nearing $7 trillion of holdings), depressing rates to lows. Domestic and International private investors, seeking greater yield, have instead crowded into IG credit. Flows into IG bond funds have averaged more than $30 billion a month in the second half of 2020. This has compressed corporate bonds to similarly low yields. BBH’s valuation framework³, as an illustration, shows only about 6% of today’s IG corporate bond universe to be an attractive buy. Such an exaggerated technical basis, alongside a mixed outlook for fundamentals, underlines the fragility in returns for spread product – corporates, municipals, and MBS. The Treasury’s elimination of the Fed Corporate Credit, Municipal Liquidity, and Term Asset-Backed Securities Loan Facility (TALF) facilities exacerbates the tail risk. For protection, we are seeking pockets in fixed income markets sheltered from the frenzied demand: smaller niche corporate and municipal sectors and much of the structured credit market.

Investing in the structured credit market can offer an attractive solution to the compensation dilemma. Traditional prime auto and credit card ABS aren’t appealing these days. Most investors know and are active in these sectors, and spreads are accordingly tight. But elsewhere – in the growing non-traditional ABS, commercial mortgage-backed securities (CMBS), and collateralized loan obligation (CLO) sectors constituting $2 trillion in present supply, the technicals tilt quite favorably to their smaller investor base. Yields, for instance, are 1% to 4% higher than comparably-rated spread product. And apart from aviation ABS, retail CMBS, and hospitality CMBS loans, the credit landscape across structured credit is notably stable, with scarcely a rating on downgrade watch. Sizable carry in structured credit is nicely complemented by their shorter 2- to 5-year tenors and modest rate duration. In the next section of this Strategy Update, we provide our 2021 outlook for structured credit alongside other sectors of fixed income where investments prospects are more daunting.

One useful reference point for value potential in structured credit is the representative portfolio for BBH’s Structured Strategy (the “Strategy”) – an IG portfolio of bonds constructed from a wide range of more than 20 ABS subsectors that today yields 4.8%.⁴ This represents a 450 bps spread over Treasuries, an unusually high lift over high-quality credit alternatives, with an average single A-credit rating, and demonstrated credit performance through the COVID downturn. The Strategy’s composite just clocked its fifth year of performance, and we note the occasion by presenting the monthly returns in figure below. The annualized returns of 4.8% over five years are compelling, and the Strategy is encouragingly poised for a similar return in 2021. Note though the consistency of returns in the chart below. Month-in and month-out (excepting March 2020 of course), the higher carry more than offsets the modest price volatility of a diversified portfolio of high-quality, short-duration ABS notes.

Structured credit stands out in value against a bleak 2021 fixed income landscape

Facing fierce competition from the Fed, foreign buyers and yield-hungry U.S. institutions, investors face a tough challenge in almost all fixed income sectors. In last quarter’s Strategy Update, we introduced a schematic of investment conditions by fixed income sector. At our clients’ request, we update it to help paint our outlook for 2021. The table on the following page outlines the current demand technical; compensation available; interest rate and spread risk; credit conditions; and ratings trajectories for each major sector of fixed income market. Red shading in a box conveys poorer conditions than historical norms; green shading suggests better-than-normal conditions.

Unsurprisingly, the large fixed income sectors in which the Fed was directly involved in purchases are painted today with a lot of red. The Fed’s massive presence has dampened volatility in these markets, spurring heavy U.S. and foreign private investment (the exception being declining overseas interest in MBS). This demand technical for U.S. government and agency paper is unprecedented, even against booming Treasury supply, and has helped drive medium and longer maturity rates to unappealing levels near or below 1%. The AAA-rated haven status of U.S. debt is still an anchor of support, but ballooning debt puts the U.S. sovereign rating on a downtrend. Fundamentals in the agency MBS market are also quite challenging in the midst of a Fed-engineered refinancing boom – prepayment speeds in the fourth quarter were among the quickest observed since 2004.

With little income available in government and agency bonds, we noted that private institutional investors have piled instead into U.S. Corporates, which catalyzed a wave of almost $2 trillion of new issuance in 2020. Corporate spreads tightened at blistering pace, and the Corporate Index’s yield of 1.7% today is the lowest recorded level in history. Furthermore, JP Morgan expects corporate issuance supply to halve in 2021, tilting technicals even tighter. With a duration in the IG Index of almost nine years, interest rate and spread risk are higher than ever. Credit fundamentals are generally fair given the macroeconomic backdrop, but patchy. Large segments of the IG and HY market remain poised for downgrade. BBH finds attractive pockets of value in the Corporate market. But it’s questionable whether depressed Corporate compensation covers the elevated risk in the average credit.

If you move outside the umbrella of fixed income with direct Fed purchase support (i.e., Treasuries, Corporates, municipals, and agency MBS), what’s left is the $2 trillion Structured Credit market. Here, durations are shorter, and yield levels are far more appealing – as they must be to continue to attract private investment.

Traditional ABS issuers – the auto companies and bank credit card issuers – have seen strong demand in recent months that has driven yields on this mostly AAA-rated part of the market to below half a percent. But on the much larger non-traditional side of the ABS market, the bond tenors are short, from two to three years, and compensation remains near its most attractive level since the Global Financial Crisis (GFC) – 3.5% in the JP Morgan Other ABS index. With technicals that still favor the investor, a strong fundamental credit outlook, and ratings watches resolving positively this summer and fall, non-traditional ABS is the only fixed income sector that screens green across the board for 2021. This is where we continue to find the most value within structured credit. For CMBS and CLOs, the investor set is similarly limited, keeping compensation in these sectors compelling. Supply this year is expected to be robust – JP Morgan projects $83 billion and $90 billion, respectively – which should bolster attractiveness. Some of the most appealing opportunities in fixed income today can be found, for example, in CMBS. But across CMBS and CLOs, investors need to sift selectively through credit fundamentals and navigate possible downgrades.

Non-traditional ABS and sectors⁵ currently command a substantial spread advantage over traditional ABS and Corporate indices, underscored by the chart at the top of the next page. While particularly appealing today, Structured Credit has historically appealed due to an absence of central bank, foreign, and many large U.S. buyers.

ABS issuance pace continued in the fourth quarter, providing a multitude of attractive opportunities for investors

New issue activity at the start of the fourth quarter continued the strong pace of third quarter. Issuers were eager to get deals done prior to the November election. Despite elevated issuance levels in October, deals were well received as demand for ABS remained strong. Issuance tapered off in November. With the ABS market essentially dormant for a couple of months during the March and April shutdowns, 2020 issuance ended the year down 23% compared to 2019.

Lower supply and confirmation of credit fundamentals have been positive tailwinds for the ABS market. We continued to see spreads tighten further in the fourth quarter. Spreads tightened most in sectors whose recovery has lagged. Spreads for traditional ABS sectors narrowed by 5 bps to 10 bps, while most non-traditional ABS sector spreads tightened in over 20 bps.

In CMBS, non-agency issuance⁶ declined in 2020 to $64 billion, half the level in 2019. In 2021, we expect similar issuance levels of $60 to $65 billion with conservative underwriting and a strong economic recovery firming investor demand. AAA-rated CMBS delivered strong total (10.5%) and excess returns (1%) in 2020 in the Bloomberg Barclays CMBS Index. More credit-sensitive BBB-rated CMBS tranches underperformed Treasuries, though, by -6%. Investor demand for more recent vintage BBB paper rebounded in the second half, while the 2012 to 2018 vintages have seen slower recoveries. We expect CMBS loan delinquency rates to continue to improve this year; however, conduit deals with higher retail and hotel sector exposure will face continued pressure. Larger SASB deals, on the other hand, should benefit greatly from well-capitalized institutional sponsorship. The opportunity set for discounted junior tranches is unusually ample for investors like BBH performing deep credit research on seasoned CMBS pools.

Given the combination of heavy issuance and attractive spreads, BBH was highly active in structured markets this quarter, purchasing just under $1 billion of non-traditional ABS across accounts and funds. Below are more notable additions.

This quarter, we began investing in recurring revenue ABS. These are securitizations of middle market loan pools to growth-stage “Software as a Service” (SAAS) companies. Direct lenders underwrite these loans based on their contracted recurring revenues rather than earnings before interest, taxes, depreciation, and amortization (EBITDA). These companies typically have revenues of more than $15 million, are growing rapidly, and so have passed the early stage of startup risk. Revenues are tied to subscription services that are essential to the operations of end-users – they are “sticky”. Golub Capital issued the first recurring revenue ABS deal in 2019 and this quarter issued their second, GCPAF 2020-1A. Since 2013, Golub has realized zero losses on their recurring revenue book. Single-A rated senior and BBB-rated junior notes were issued with substantial credit enhancement of 38% and 29%, respectively. We participated in these at spreads to Treasuries of 290 bps and 420 bps, respectively.

Similarly, Alliance Bernstein issued their first recurring revenue ABS, ABDLF 2020-1A, with a two-year reinvestment period. They also have a spotless record lending since 2011. We participated in the A-rated senior notes and BBB-rated junior notes spreads to Treasuries of 296 bps and 471 bps, respectively.

It was a brisk issuance quarter in middle market CLOs for these same lenders. The deals we were involved in are all new “post-COVID” deals; i.e., are clean of any troubled loans related to the pandemic. Alliance Bernstein issued ABPCI 2020-9A, a new-issue middle market CLO with a 3-year reinvestment period. Alliance Bernstein is a highly-experienced middle market lender specializing in first-lien lending and they hold all the equity beneath their CLO debt. We were in the A-rated and BBB-rated tranches at spreads of 400 bps and 620 bps to 3-month London Interbank Offering Rate (LIBOR), respectively.

NXT Capital issued NXTC 2020-1A, a new-issue middle market with a 3-year reinvestment period. NXT Capital, a subsidiary of ORIX Corp, is another seasoned first lien direct lender that holds the equity under their CLOs. We participated in the AAA and A-rated tranches at spreads of 185 bps and 335 bps to 3-month LIBOR, respectively.

Golub issued its second TALF-eligible CLO (GCTLF 2020-2A), a new-issue static middle market CLO. We took advantage of the AAA and A-rated tranches issued at spreads of 185 and 365 bps to 3-month LIBOR, respectively.

SYMP 2020-23A is a new-issue post-COVID bank-syndicated CLO portfolio managed by Symphony, a subsidiary of Nuveen/TIAA. We were in the BBB- rated tranche (3-year reinvestment period) at a spread of 430 bps over 3-month LIBOR.

BBH was also a major participant in the corporate debt of business development corporations (BDCs), another attractive corner of the direct lending market. Although the notes hold a general rather than secured claim on a BDC’s direct loan assets, the high asset coverage of BDC notes is similar to ABS notes. Total debt-to-loan assets are low – ranging from only 35% to 55% - and are capped by law at 66%. BDC notes hold up to the same or tougher stress cases as our ABS and CLO holdings. We purchased BBB-rated debt from the BDCs of Blackstone GSO, Owl Rock, and Stellus Capital at spread of 290 bps, 350 bps, and 440 bps over Treasuries, respectively, as well as A-rated debt from Gladstone Capital at 475 bps over Treasuries.

BBH also helped lead the first “dark fiber” ABS securitization this quarter, FIBER 2020-1A, issued by Summit Infrastructure Group. The notes are secured by all present and future lease cashflows generated on a lightly-utilized underground fiber network located in Northern and Central Virginia (“Data Center Alley”). Summit IG’s primary business is to provide local interconnections for the critical infrastructure of Cloud carriers (Amazon, Google, Microsoft) and large-scale enterprise clients. We participated in the 5-year A- and BBB-rated classes at spreads of 190 bps and 280 bps to Treasuries, respectively.

We were also involved in MCA 2020-1, the third collateralized fund obligation (CFO) issued by CUNA, a leading insurer to U.S. credit unions. The CFO is backed by a diverse seasoned portfolio of private equity fund investments, originated by CUNA Mutual under its alternatives portfolio. Three-year A- and BBB-rated tranches were issued at spreads to Treasuries of 310 bps and 410 bps, respectively.

Aircraft ABS made a surprisingly swift market return with BJETS 2020-1A, backed by a closed pool of full-recourse corporate jet loans and leases to high-grade corporations and wealthy individuals. Issuer Global Jet Capital is a lift-out of GE Capital’s business jet leasing team and portfolio and, in total contrast with the experience of commercial aircraft lessors, has had zero delinquencies through the pandemic. We were in the 4-year A- and BBB-rated tranches at spreads to Treasuries of 273 bps and 371 bps, respectively.

Midcap issued its fourth venture debt ABS deal (MDCP 2020-4A), secured by loans to venture capital-backed, publicly traded life sciences and technology companies. We took advantage of the 3.5-year A- and BBB-rated tranches with spreads to Treasuries of 208 bps and 400 bps, respectively.

We were also involved in bricks-and-mortar personal consumer loan ABS issued by Republic Finance. Notes rated AA, A, and BBB came at spreads of 220 bps, 325 bps, and 382 bps over Treasuries, respectively.

We continue to find very attractive AAA-rated opportunities across many ABS asset types. We participated in the unique premium finance ABS shelf of PFS at 80 bps, in a senior tranche of Credit Acceptance’s subprime auto program at 110 bps, and in several servicer advance ABS classes at 90 bps to 110 bps over Treasuries.

The CMBS market, with more tentative sponsorship, currently offers unusually attractive opportunities on value and credit grounds. We participated in BFLD 2020-OBRK, a floating rate CMBS collateralized by an open-air super regional mall Oakbrook Center in Chicago’s suburbs. The AAA-rated senior note had a notably conservative appraisal loan-to-value (LTV) of only 26% and came at 205 bps over 1-month LIBOR.

We also invested in a CRE CLO issued by market leader Blackstone Mortgage Trust (NYSE: BXMT). BXMT 2020-FL3 is a $1 billion issue collateralized by 71 properties. We participated in AAA and A-rated notes at 140 bps and 255 bps over 1-month LIBOR offering credit enhancement of 48% and 24%, respectively, on top of borrower average equity of 33%.

Saving the best for last, for accounts eligible for unrated issues, we participated in the subordinate B-piece of agency CMBS transaction FREMF 2020-KL06, which comprised the lower 8% of the $411 million issue. An unusually well-structured Freddie K deal, the senior mortgage loan is cross-collateralized by a 10-property multifamily portfolio located across six states, fully leased, and with an estimated market LTV of only 66%. The 9-year note has a yield of 8.8%.

An allocation to structured credit allocation can provide welcome yield and credit advantages in the new year

Back in March of 2020, we drew confidence from our many direct conversations with the senior management teams of our issuers. It has been gratifying to see our credit performance expectations confirmed in monthly remittance reports over the last nine months. With the exception of aircraft ABS, we now see little scope for impairments or downgrades across the entire ABS market. We continue to expect investment grade tranches of CMBS and CLOs to perform. Yet compensation available across structured credit remains compelling: in absolute terms, against the norm of the last decade, and versus a broader credit market near historically low value. As BBH’s Structured Strategy exemplifies, a short duration portfolio of non-traditional ABS, diversified across 20 subsectors, and with an average A-rating, can provide investors a yield over 4%.

To our investors, we look forward to describing this rich opportunity set with its durable credits⁷ in the new year.

Sincerely,

Portfolio Management Team

Neil Hohmann, PhD
Head of Structured Products
    
Chris Ling
Structured Products Trading
    
Andrew P. Hofer
Head of Taxable Fixed Income