Asset Backed Securities : Resilience in uncertain times

  • 28 May 2024 (10 min read)

Key takeaways :

  • Slowing growth, higher-for-longer rates and volatile markets mean investors have to look further to find yield without excessive risk.
  • ABS have proven their resilience in previous periods of market stress. They also tend to offer investors higher spreads compared to fixed income assets with similar ratings. 
  • Today ABS gives investors a unique access to consumer assets, important diversification benefits and attractive spreads in a highly liquid market. 

How can the higher rate environment, which is squeezing borrowers, create opportunities in Asset Backed Securities (ABS)? The ABS market has undergone significant changes over the last decade, especially from a regulatory perspective, and today offer investors very attractive yields and highly defensive performance in times of volatility. Given the current market environment, we believe this could be a great time to add ABS to an institutional portfolio.

Economic headwinds and volatility require resilient portfolios

Interest rate uncertainty accompanied by slowing global economic growth means investors have had to look closer at where they can find the defensive exposure they expect from bonds, while still getting sufficient yield. This has become even more important as inflation remains high, and investors need to make up the shortfall between cash rates and inflation. 

The high level of rates is now also starting to take a toll on consumer spending, which will likely lead to a slowdown in growth. Over the last few years ABS have been highly resilient and offered less volatility than IG credit.

Diversification and collateral backing create resilience
Source: AXA IM, Bloomberg, April 2024. Senior ABS Index : BFABTREH, IG Credit : ER00

We recently highlighted in our Alternative credit outlook why we believe the heightened level of market volatility will be around for some time. We also expect rates to stay higher for longer and geopolitical risks to remain. In this environment ABS can offer investors more protective features. 

For example, the ABS market proved extremely resilient throughout the onset of the Covid pandemic and during the heightened market volatility in Q4 2022 (figures below). This downside protection is largely due to the backing of high-quality, defensive collateral.  

March sell-off in 2020
2022 sell-off
Source: AXA IM Alts for illustrative purposes only. Indices represented by the following (Bloomberg tickers): ABS Index: BFABTREH, IG US Corporate: C0A0, IG EUR Corporate: ER00, EM Corporate: EMCB.

Investor-friendly features and regulatory changes

There are a few key reasons behind these characteristics. ABS are floating rate notes, and therefore have very low duration. Secondly, ABS are in general short dated by nature. Thirdly, ABS tranches amortise over time, where principal repayment is made on a regular basis (monthly, quarterly). Amortisation is for example common in ABS/RMBS, but much less common in traditional corporate debt, where the principal payment by the issuers is usually made at maturity. This amortisation reduces the refinancing risks. All these features combined contribute to the very stable performance in times of elevated market stress.  

Default rates need to rise significantly for ABS tranches to incur losses
Source: AXA IM, Intex, Moody’s and LCD , June 2023. Intended portfolio composition ABS minimum rating BBB-.

Some of these features are due to a new securities regulation that came into effect in 2019, where a simple, transparent and standardised label was put in place by the EU to establish a capital markets union and to ensure a high degree of protection for investors.

In short, the new rules are much more stringent regarding due diligence, risk retention and transparency for securitised products. This change has led to a more transparent market, as loan-by-loan data from originators is now mandatory and it has also resulted in more favourable Solvency II treatment across the ABS capital structure. 

Yield without moving down the quality scale

While the high interest rate environment continues to weigh on corporates and consumers, ABS have performed relatively well as underlying factors remain positive:  consumer assets are supported by low unemployment rates and corporates have been in a benign default environment. 

High interest rates also bring about positive aspects from a yield perspective. The floating rate nature of ABS instruments ensure that all-in-yields are – and if our view on rates is correct – will continue to be highly attractive, especially on a risk adjusted basis. As can be seen in the table below, Investment Grade ABS assets tend to offer higher yields than traditional Investment Grade fixed income assets. 

ABS spreads provide attractive relative value at equivalent rating
Source: AXA IM Alts and Bloomberg. March 2024.

Diversification in a choppy market

Given the macro headwinds we have already mentioned, we believe diversification will play a key role in portfolio performance this year. The ABS market covers both consumer, corporate and real assets and it is therefore a useful diversifier. 

To give an example of this, we have looked at 10-year historical volatility and through a simulation shown that by adding ABS to a typical fixed income portfolio (comprised of global government bonds, euro/US corporate IG credit, euro/US HY credit and some Emerging Market (EM) corporate debt) the level of volatility can be drastically reduced. And as the chart shows, by adding ABS to a portfolio, the lower volatility would contrary to what could be expected not result in a lower, but a higher spread. 

Figure 3: Model fixed income portfolio
Source: AXA IM as at 31 August 2023, provided for illustration purposes only. *10-year historic volatility used as a proxy for risk. Further detail regarding the underlying asset allocations held within each portfolio is provided at the end of the page.

An asset class backed by the real economy 

Today, the ABS market is supported by a well-established investor base across money managers, bank treasurers, insurance companies, pension funds and other investors looking for high-quality, investment grade alternative fixed income investments. It offers investors a unique access to consumer assets, as well as to corporates and real assets. Due to the breadth and depth of economic activity that ABS supports, opportunities to gain selective exposure to specific areas of the consumer economy are vast. 

ABS have proven their resilience during previous bouts of market stress, partly due to the improved liquidity because of significant regulatory changes. Despite this, the asset frequently offers wider credit spreads than comparable lower-rated IG credit – which unlike ABS, is a largely unsecured asset class. With higher-for-longer rates, we believe the ABS market is a great source of value in liquid credit markets today. ABS offer high credit ratings, security against tangible assets (such as property) and robust structural safeguards to maximise the probability of repayment.

Model portfolio details
Source: AXA IM data as at 31 August 2023.


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