How Concerned Is The Fed With The Yield Curve?
European ABS market performance and volatility have been remarkably stable since 2016, largely weathering broader credit weaknesses so far this year. Through extended periods of positive spread performance, primary market deals often price in very tight ranges and it is easy for a degree of complacency to set in on how to assess a fair steady-state spread basis between different investments.
However, in recent weeks pricing differentials have developed, suggesting a return to a more normal market environment where risk-tiering is a more prominent consideration.
One reason for risk-tiering is a strong but also more diversified ABS primary market when compared to 2017, handing investors more choice. ABS issuance in the UK has grown strongly at €9.1bn year-to-date in line with expectations; but whilst we felt continental ABS issuance volumes would surpass most researchers paltry forecasts, we expected it would occur later in the year as tapering noise grew louder. However, year-to-date continental ABS issuance already totals €17bn vs €29bn in the whole of 2017. CLO issuance has continued its strong growth trajectory with 3 new managers featuring and CMBS issuance has resumed with 4 transactions so far from a near zero base last year. This has provided a surprising net growth in market size year-to-date of €2.3bn, so far bucking the expectations of some market commentators such as Morgan Stanley’s who forecast a shrinkage of €8-10bn in 2018.
Risk-tiering has so far been contained in a few specific pockets. The most obvious example is within CLO’s where a broad array of managers have brought deals to market.Varying investor perceptions of manager quality, portfolio and deal structure has generated tiering at the BBB level of around 30bp up from 10bp a few months ago.
Within UK RMBS varying factors play a part. Underlying credit quality is more pricing sensitive, and recent AAA Buy-to-Let RMBS deals saw a 25bps spread basis (with Paragon, a long established issuer who having obtained a banking licence and gained access to central bank funding have been absent from the market since 2015, pricing at the tight end) which is a significant differential for a low credit risk asset. Recent CMBS deals in our view have all had a healthy risk tiering that reflects very different strategies and structures. For example, deals with heavy retail exposure or where valuations give rise to concern have priced wider.
Continental ABS has so far been less sensitive to tiering given the demand from local investors and a healthy scarcity premium. This will likely change as issuance volumes and diversity there increases.
There are also a few areas of focus where we consider and attribute tiering that is perhaps not always reflected simply in pricing. Deals where we consider alignment of interest to be weaker may underperform should fundamentals deviate from the current strength. There has been a lack of term premium between the standard 3 and 5 year deals, which issuers were happy to capitalise on, however this might cease to be the case as the cycle progresses. Transactions where interest rate risks are not perfectly hedged might be more prone to re-pricing. Consider in the UK some deals where mortgage borrowers pay a margin over Bank of England base rate and bond liabilities use 3m GBP Libor (a 15bps negative basis currently, but as much as 29bps just a few weeks ago) or floating rate Spanish mortgages which reset annually with the bonds typically quarterly. We would emphasise on this point that structural protections such as cash reserves and credit enhancement are built-in to transactions to absorb this impact.
We are relieved to see risk-tiering playing a larger role in the market. Aside from being more appropriately compensated for risks, it allows us to add more value through stock selection and active management.