Time to extract Europe’s elevated bond spreads
The European ABS market has reopened strongly in the early weeks of 2023 with a spurt of new issuance and a parallel rally in spreads, mostly driven by positive technical dynamics as investors have entered the new year with cash to invest and buoyed by renewed hope that inflation has peaked and central banks are approaching terminal rates.
This is a welcome change for investors after a slow December closed out an exhausting Q4 2022, which featured the biggest liquidity test for ABS since the global financial crisis. Total European ABS issuance reached €78bn in 2022 including €26bn of CLOs, considerably lower than the figure for 2021 and with only 14% of the total issued in Q4.
The first deal of 2023 came from Yorkshire Building Society, a £525m reissue of the AAA RMBS tranche that the lender priced and retained in Q3 2022. A 2.9x covered order book and the participation of 29 investors showed there was ample demand for high quality liquidity assets, and allowed initial price thoughts of Sonia +70bp area to be tightened to a final spread of 63bp. The deal also opened the door for other issuers, and a few days later Coventry Building Society priced its own £350m AAA RMBS tranche at Sonia +56bp (a yield of 4.5%), reporting an order book of well over £1bn dominated by bank treasuries and asset managers.
With UK prime issuers having reopened the market, we expect the positive momentum to continue and for other issuers to use this window of favourable market conditions to respond to their financing needs. Two further RMBS deals have already been announced, and we expect a new issue pipeline of more diversified transactions across sectors and jurisdictions, with some mezzanine bonds on offer, to build over the next few weeks.
On the CLO side HPS was the first manager to emerge with a new deal, pricing its AAA bonds at 3m Euribor+205bp (with Euribor currently at 2.3%) and the floating BBB and BB rated tranches at euro yields of 8.5% and 11.4%, respectively. Each tranche was multiple times oversubscribed (from 2x on the senior notes to over 5x for the BBs) driven by investors’ preference for a 81%-invested portfolio of mainly senior secured loans, comparing favourably to many 2022 deals that arrived with only 20-30% of the portfolio invested. To us this was a sign of broad appetite for risk assets right across the rating spectrum, another drastic change from 2022 when for much of the year existing warehouses (vehicles which hold assets for CLO managers while they prepare to issue a CLO to the market) were difficult for managers to convert into new CLO issuance thanks to volatile markets and a lack of demand. This created a backlog of CLO warehouses waiting to be issued as CLOs, sending new warehouse registrations 40% lower in 2022 vs. 2021 and suggesting lower CLO issuance in 2023.
The ABS and CLO markets were lagging the rally in broader credit back in December, but they have quickly caught up, with BBB and BB CLO spreads tightening by as much as 100bp year-to-date. The heavy and diversified BWIC supply we’ve seen in the first two weeks of trading showed strong participation, with investors ranging from LDI managers coming back to the market to US hedge funds buying mezzanine CLOs. Clearly there has been some profit taking from investors that bought assets at discounted levels post the UK mini-Budget fiasco, but we can also see BWIC auctions generating a lot of investor interest and spreads are gradually tightening in mezzanine ABS as well. These BWICs provide useful market colour and we are seeing secondary pricing move on the back of it.
We expect this strong technical to remain in place in the near term, and despite the flurry of primary activity we think investor demand is more than sufficient to absorb it.
We remain mindful of likely volatility in 2023, given a looming recession and other uncertainties. However, the income now available in ABS (A and BBB rated UK RMBS notes are trading at 7-8% yields in GBP) gives investors a very different starting point compared to 2022, and that income (keep in mind floating rate coupons are higher as Sonia is now at 3.4%) can also help protect portfolios from any volatility to come.