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A Midsummer Tight-market’s Dream (come true?)

17 August 2016 by Rob Ford

We are currently deep into the middle of the summer holiday period and markets are traditionally and understandably quieter at this time of year, with many participants sunning themselves on the beach – the lucky so and so’s…

That said, markets do continue to trade, and whilst shallower liquidity may be exaggerating movements a little, they continue to move in one direction; we have already written on several occasions this month about the incredible price action seen in fixed income over the last month or so.  Following last week’s blog Laying down a challenge we were asked for more insight into how good the relative value of yields in the ABS market currently are.

So-called “risk-free” assets (core government bonds) now yield virtually nothing in the UK and less than nothing in Europe.

Similarly, Covered Bonds barely yield above Libor in the UK, and for the most part have negative yields in core Europe.

Corporate Bonds, the latest target of both the ECB and the BoE’s invigorated economic stimulus programmes, have also seen tremendous rallies with the BAML Euro Corporate Investment Grade Index now yielding just 0.63% with a duration of 5.3yrs and an average rating of A3, whilst the UK equivalent index yields 2.09% with a duration of 9.1yrs and the same A3 average rating.

Even high-yield markets have caught the wave with the benchmark Crossover Index now trading with a yield of less than 3%.

Away from fixed income, stock markets worldwide have been rallying hard and most major indices are at highs for the year and in some cases for their lifetime.

So where does the discerning investor look for attractive returns from high quality assets, that haven’t yet had all the juice squeezed out of them?  If you haven’t guessed already, it’s Asset Backed Securities (ABS).

Whilst the senior parts of the ABS market in Europe have been part of the ECB’s ABS Purchase Programme for over 18 months, yields there have already been squeezed somewhat.  In the UK, the BoE’s announcement following the recent MPC meeting, of a new £100bn Term Funding Scheme alongside the base rate cut and QE measures, has brought concerns of a possible RMBS supply shortage from the banks as they turn to cheaper funding from the new scheme; this has caused senior RMBS spreads to tighten sharply in the last week or so.  However there is still significant value in the UK when compared to many European assets, and certainly when compared to similarly rated Covered Bonds.

And let’s not forget, ABS is a floating rate product – and therefore carries virtually no interest rate risk.  A 5-year fixed rate bond with a coupon of 0.5% needs only to see a 10 basis point upshift in yield to wipe out an entire year’s worth of coupon income!

In the investment grade part of the ABS market, significant relative value remains over comparable credit products.  In higher yielding ABS the pick-up is even more compelling.  Looking at just two sectors for example. The UK specialist mortgage lending RMBS market (originators such as Paragon, the Buy-to-Let specialist and Kensington Mortgages) offers returns at the AAA level of approx. Libor plus 1.5% (the 3-month Libor “plus” component may now only be a measly 39bps following the base rate cut, but that’s still almost 70bps higher than 3-month Euribor in Euros!).  Further down the investment grade spectrum yields range from Libor+2.5% or more for AA-rated bonds and Libor+4% for BBB.  Returns in investment grade CLOs are similar, and in high yield territory the BB-rated bonds yield approx. 7% and single-B approx. 9.5%.

As a result, we’ve recently been adding both these sectors and other asset classes to several of our ABS strategies because their yields have been lagging those in conventional credit markets.  The chart below shows a wider selection of European ABS spreads compared to relevant corporate bond sectors.

Sources: Barclays, Bloomberg, Citibank, TwentyFour. 16-Aug-16

“Why is this”, you might ask?  Well undoubtedly the ABS market continues to suffer somewhat from its association with the US assets that helped to bring on the financial crisis, despite the fact that the assets underlying most European ABS have actually performed extremely well throughout the whole period, with minimal losses experienced, however, the memory of that negative stigma still pervades amongst some market participants.  In addition, the market needs more specialist analysis, by its nature, it is more complex requiring expertise beyond that of a generalist credit investor.  This means there are less players and therefore market movements tend to lag general markets – a lag that can be utilised to the smart investor’s benefit.

So wherever you may be at this time of year – on the beach, or less appealingly, in the office – if you are praying, nay fantasising, for some real yield in a no yield environment, then maybe giving the European ABS market some further consideration could indeed be a mid-summer’s dream come true!

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