Henderson's Ed Panek hunts value in the world of asset-backed securities, and predicts an increasing number of pension schemes will look past the problems of the last financial crisis, in the latest Technical View.
However, it is focusing on their defensive properties that may provide the greatest opportunity over the years ahead. This may appear counter-intuitive given the negative press the asset class has experienced since 2008.
But if we look behind the headlines, we discover that not all ABSs are created equally.
Key points
ABSs have attractive excess returns compared with investment-grade corporate bonds
They also provide security over a pool of assets and mitigate against corporate event risks
Floating-rate assets provide insulation from the effects of market interest rate rises
Unlike the residential mortgage-backed securities issued in the US that were backed by loans made to high-risk borrowers and subject to lax underwriting practices before the onset of the global financial crisis, the fundamental credit performance of European ABSs has, for the most part, been very different.
According to Standard & Poor’s, defaults on all outstanding European assets from mid-2007 to September 2013 were a cumulative 2.6 per cent, compared with those from the US which show cumulative defaults for the same period of 18.4 per cent.
Moreover, the defaults in Europe have almost entirely been concentrated in the subordinated and therefore higher-risk and return classes of ABSs issued.
Losses on the more defensive senior bonds issued have been negligible, notwithstanding the extreme macro challenges that Europe has faced over this period.
While there has been a lot of debate regarding the complexity and transparency of these assets, in many respects these transactions can be viewed as a single-purpose credit institution with a tightly controlled asset portfolio, in the underlying loans – and appropriately matched liability profiles in the debt tranches purchased by investors.
These, in essence, are characteristics that politicians and supervisory bodies are keen to encourage within banks. Indeed, the important ongoing role that ABSs can play in facilitating the flow of credit to the real economy is increasingly being championed by central bankers.
Initiatives such as the European Data Warehouse to encourage the availability and standardisation of data on underlying collateral portfolios are positive developments, but as with corporate bond issuers, there will always be the good, bad and indifferent in terms of financial disclosure quality. It will remain the role of expert analysis to differentiate.
Constructing your portfolio
As these assets are often secured by large and diverse pools of assets such as mortgages or consumer loans, they are somewhat insulated from the corporate event risks such as merger and acquisition activity, which can affect company debt.
New legislation that will facilitate the automatic writedown or 'bail-in' of unsecured bonds to help recapitalise struggling banks is one example where this security may prove to be highly valuable in the future.
More generally, an allocation to ABS can broaden the diversity of risks and return contributors available when constructing a fixed income portfolio.
With ABSs typically earning interest that is linked to a floating rate, such as Libor, returns should provide insulation from the pressure of rising interest rates on traditional fixed-rate bond portfolio valuations. Indeed interest income would increase as Libor rates rise.
As pension schemes mature and seek to implement derisking strategies, an increasing number are exploring ways to generate relatively stable Libor-plus returns.
The excess returns achievable over Libor will vary depending on the strategy risk profile, but a target range of Libor-plus 1-1.5 per cent a year should be achievable while maintaining a defensive bias.
This represents a material pick-up in the excess returns that may be available from an investment-grade corporate bond portfolio with a similar rating and maturity profile.
ABSs have not comprised a significant proportion of most pension fund portfolios, and where they have invested it has tended to be to exploit a tactical value opportunity.
This will change over the coming years as an increasing number of pension funds have the confidence to differentiate, look beyond the crisis headlines and seek to capture the returns available from the asset class.
Ed Panek is head of ABS investment at Henderson Global Investors
