Investors have flocked to traditional bonds in the aftermath of the UK’s vote to leave the EU, despite these perceived ‘safe havens’ offering low or negative real yields. European asset backed securities (ABS) offer higher yields, and the majority have floating rate coupons which protect investors against interest rate duration risk.
Since the referendum European ABS were affected by rising risk premiums in most sectors, including those not directly exposed to the UK. This is creating opportunities to invest in ABS at attractive valuations.
Beyond Brexit related opportunities, we are currently investing in pools of corporate loans through collateralised loan obligations (CLOs). Senior CLO tranches are very well protected from defaults and pay relatively high risk premiums. The floating rate coupons are based on the Euribor plus a spread. For most CLOs issued since mid-2015 the Euribor reference rate is subject to a floor of 0%, which means that even if the Euribor falls further into negative territory, they will still provide positive returns. (see chart below for a comparison between pre- and post-crisis EUR CLOs)
"Post crisis" CLOs with more resilient structures:
Chart 1: The chart above shows a comparison between pre- and post-crisis EUR CLO structures. Credit enhancement – measures to improve the credit profile of a structured finance transaction – for AAA investors has increased from 32% to 40%, while the coupon has increased from Euribor +22bps to Euribor +145 bps.
We also like commercial mortgage backed securities (CMBS). Many ‘vintage’ transactions issued before the financial crisis still trade below par and are fast approaching maturity, as the collateral portfolios are being liquidated. The best opportunities are in transactions which have the potential to repay earlier than expected and provide a ‘pull-to-par’ effect.
The European ABS market continues to recover from the global financial crisis, but has not yet shaken off the stigma created by its US equivalent. The market has found a new equilibrium, but not yet fully normalised. While creditworthiness has improved, the credit spreads available today are still several times higher than in 2007, providing access to resilient structures offering higher returns over government debt than in the pre-crisis era.
Regulatory treatment under Basel III and Solvency II continues to hinder ABS, with capital requirements putting the market at a disadvantage versus corporate bonds and covered bonds. This makes the issuance of ABS more expensive and is reducing the number of new issues coming to market, restricting alternative funding to the real economy. The EU’s Capital Markets Union initiative goes some way to addressing low issuance by creating rules defining simple, transparent and standardised (STS) securitisations. While STS has the potential to boost the market, the wider regulatory treatment of ABS needs to be addressed to fully support funding and investment opportunities.