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This Time Next Year….ABS Addendum

19 December 2017 by Douglas Charleston

Mark recently set out TwentyFour’s collective house view for the coming year (This Time Next Year 2018) and so as Portfolio Managers on the ABS desk, today’s blog interprets how we intend to implement to our corner of the fixed income world.

When considering key ABS performance drivers next year, it is hard to get far without debating the direction and speed of change in monetary stimulus from the ECB and Bank of England.  We think that ECB tapering will start in late 2018, but given the Asset Backed Securities Purchase Programmes (ABSPP) modest €25.43bn size, short weighted average life and extremely small credit concerns, this small cog in the QE machine will be best unwound by letting it roll off organically. The cost, signalling and potential disruption of selling ABS bonds does not stack up when a key policy objective is to bring the market back to life. We expect much more time and attention is paid to longer duration fixed rate bonds held in the corporate and covered bonds buying programmes. In fact, a bearish rates view in Europe might in itself create a stronger demand for a floating rate product like ABS.

The macro picture across Europe remains very constructive with key ABS drivers like unemployment, wage growth and stable asset valuations expected to make further gains across most of the bloc. Dutch unemployment has dropped 1% to 4.5% in 2017 so far, and Spain has seen a 10% drop in its rate to 16.8% since the high in 2013 (coinciding with 6.7% YoY house price growth in Q3; the strongest increase in over a decade). Recently revised OECD forecasts see Eurozone GDP growth stable at 1.9% out to 2019, with moderate wage growth keeping pace with inflation which is unlikely to break through 2%.

There are a few pockets of concern that we have flagged consistently in 2017. Firstly, the UK clearly has risk relating to Brexit, but for ABS, weaker house prices alone do not create issues. We need falling wages and very high unemployment to create meaningful defaults in mortgage or consumer debt portfolios (ignoring for a moment the protection provided within an ABS deal), and it is hard to see these come through to the required extent, even in a “no deal” Brexit scenario. The general increase in household leverage is also of note, however we do not see sufficient upward pressure on interest rates from the BOE to make this broadly unsustainable. Other risks relate to the relaxation of loan covenants in leverage loans backing CLOs and sectoral shifts in commercial property markets, where retail properties in particular face structural hurdles over the short and medium term. However, the picture by and large is one of a fertile ground for underlying ABS bond performance and we expect this to be reflected in another year of stable or upgraded ratings, further differentiating performance with corporate credit markets.

Another key theme for 2017 was the technical impact of new issuance continuing to be eclipsed by legacy transaction paydowns and renewed investor appetite across European senior and, in particular, mezzanine bonds in any currency. Morgan Stanley research projects that 2018 placed issuance will reach €72bn (down from an expected €84bn in 2017) resulting in a net reduction in outstanding bonds in the region of €10bn. However, the shrinkage in outstanding bonds is slowing down – whilst it diminishes one variable in the technical equation (the other being fresh regulatory driven investor demand), we welcome a stable level of outstanding bonds as a key step to long term sustainable growth. Our view for 2018 is slightly more optimistic on issuance volumes, the amount of issued bonds retained for ECB repo purposes is roughly the same size as placed issuance currently and we believe that a number of European banks will begin to gradually dust off issuance platforms in anticipation of normalised funding needs. In the UK, this will likely start in earnest in 2018 where the end of the Term Funding Scheme will increase bank issuance in an orderly manner, and though a busy Q1 may cause some jitters among some participants, full year issuance will be reflected on as ‘palatable’.

The final theme that will materialise towards the end of 2018 is the start of a series of private equity backed deals which come up for their optional calls. PE houses entered European markets in size in 2014 and 2015, acquiring assets from banks who were struggling with capital and keen to de-lever. With funding spreads now materially tighter and asset values elevated, their exit timing seems perfect and the question is will the banks and real money investors fill the void?

Our navigation of these risks and opportunities begins from a position of spreads near their post-crisis tights in some parts of the market and whilst still representing a healthy premium to other credit products, which are also trading at tight spreads, we favour a slightly defensive footing. We are cautious in our credit approach by taking advantage of the rich data tapestry at our disposal in ABS to monitor, benchmark and forecast underlying performance within what are complex structures. We also place a lot of emphasis on site visits to asset originators, servicers and managers in the case of CLOs. Whilst it can be a slightly arduous task visiting remote parts of Europe, what we often find are very experienced teams, important contacts and invaluable early warning indicators.

We favour deal structures which provide strong call protection in the form of penal coupon step-ups, strong sponsor business plans and the importance placed on ongoing capital market access. The other essential component is the economic skin in the game of a sponsor. If things go wrong, will it hurt the sponsor? Will they do the right thing by bond holders? We consistently communicate that default rates in European ABS markets have been and are expected to remain amongst the lowest of any asset class, however the slippery snakes of tomorrow could provide mark to market volatility which are just as unpalatable in the short term. For CLO markets, we see a greater manager premium emerging as capability and style are likely to be more closely scrutinised at the more mature part of the cycle.

So looking forward, we continue to see most value in European CLOs, particularly at the BB level for its risk-adjusted return and in low convexity UK RMBS with lower credit duration, strong liquidity and Brexit premium. We also expect to see more CMBS deals in 2018 (which would be welcome) whilst acknowledging these will be considered on a case by case basis. The team also spends more time on equivalent private transactions which offer a value premium, more tailored risk exposure and ongoing partnerships. We favour shorter credit duration but as always, active management and a nimble approach will be key to generating returns.

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