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Technical Strength, Structural Weakness

1 March 2017 by Douglas Charleston

We recently highlighted how Technical Strength in the ABS market has been a key contributor to performance so far in 2017. With fundamental performance across underlying mortgage, consumer credit and loans sectors broadly benign, technicals will remain an important driver.

In the midst of a strong European credit rally we have seen tell-tale signs of exuberance in the high yield sector where weaker credits price at strong levels and covenants in loan markets soften around the edges. In ABS markets, tightening spreads and limited supply have manifested into some more aggressive transaction structures.

The amount of leverage that an ABS issuer can achieve is affected by several elements; the quality of the underlying portfolio, yield on the pool, rating agency criteria, and is typically capped at 20x as a result of the 5% risk-retention minimum by the sponsor. The other key driver is the cost of the liabilities, which at current levels are more favourable than at any time since 2014. A good example of this is Finsbury Square, a 20x levered near-prime UK RMBS transaction where a very similar April 2016 transaction issued bonds rated AAA to BBB whilst a newly priced deal achieved the same leverage by issuing bonds down to single-A. This is exacerbated where issuers opt for differing step-up margins at the call date.

We have seen a variety of other issuer friendly features in some RMBS deals; for example coupon step-ups margins which are not rated by the agencies such that ratings are more easily obtained all else remaining equal. This in our view results in less transparency when comparing similar rated bonds. Also so called ‘WAC Caps’ which cap the bond coupon that is paid when it exceeds the weighted average interest rate on the underlying assets. The additional stepped up coupons are then paid junior, and in some cases we have doubts whether full coupons will be received.

The bottom up part of our investment approach which dives into bond structures is therefore increasingly important against a seemingly benign and arguably under-priced geopolitical backdrop. First and foremost, we assess Sponsor Risk; who are they, are they a likely repeat issuer, is this a ‘trade’ and do they have real ‘skin in the game’? Secondly and closely linked, Call Risk; having assessed the sponsor, how badly does it hurt them if a deal is not called on a scheduled date, and are we suitably compensated through stepped up bonds margins in the event a bond extends? If a bond does extend, we assess how painful this might be for yield and also market value. This varies by type of asset and seniority of bond; for example a pool of 5 year auto loans will extend far less than a mortgage-backed deal comprising 25 year loans.

These are always important considerations for the ABS portfolio management team but are heightened when spreads are tightening. A favourable risk-adjusted return can often be found in older more seasoned deals which the market already prices to worst. Although strong fundamentals are important to getting our money back eventually, stock picking is ever so important in a bull market as structural weakness can come back to haunt you when markets soften.

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