Asset Backed Securities – The Final Frontier of Investment Jargon

What do actresses Margot Robbie and Selena Gomez, alongside celebrity chef, Anthony Bourdain, have to do with investing? Well, those who are fans of Michael Lewis’ blockbuster film, The Big Short, may remember that these A-listers were drafted in to help attempt explain the securities that sat behind hedge fund manager, Michael Burry’s, big bet against the US housing market.

These fourth-wall breaking interludes were necessary to try and shine a light on a part of the investing universe which is chock-a-block with acronyms and heavy investment jargon which obfuscates a market which can offer attractive return characteristics for those able to take advantage of their complexity premium and unfair reputations. In this article we explore and elucidate the world of asset backed securities and explain, in particular, how they can be a worthwhile component of a multi-asset portfolio.

Unravelling the Jargon

Asset Backed Securities (or ‘ABS’ – our first acronym) are typically publicly-traded bonds which are backed by the income and collateral of a portfolio of loans. There are different varieties of ABS bonds depending on what kind of loans they are backed by (this is where the jargon starts to get heavy).

1. CLO* – Collateralised Loan Obligation – Portfolios of loans made to companies.
2. MBS* – Mortgage Backed Securities – Portfolios of mortgages secured against residential (RMBS) or commercial (CMBS) properties.
3. Auto ABS – Auto Asset Back Securities – Portfolios of car loans.
4. Credit card receivables – Portfolios of credit card debt.

* The CLO and MBS markets are the biggest in the European ABS market.

The European ABS Market

Source: TwentyFour Asset Management, Waverton. As at 29 April 2024.

Unravelling the Structure

At a fundamental level it might not seem revolutionary to imagine a portfolio of loans being pooled to generate a single, aggregate income and capital return (one might make the comparison to a vanilla corporate bond fund), but unfortunately the structuring of ABS is anything but simple. This complexity presents opportunities for those able to navigate the market, as we’ll discuss later.

Tranching – Each ABS transaction, instead of just being a single fund or bond, is split into multiple layers. These layers (or ‘tranches’) receive income and principal payments from the underlying portfolio at a rate depending where they are in the stack – the safest tranches (often given AAA designations by ratings agencies) are the first to receive their set coupon payments and have the highest claim over the underlying assets. In contrast, the lower ‘mezzanine’ tranches will have to absorb default losses on the loan portfolios ahead of the higher rated tranches; in return, however, the lower the tranche, the greater the coupon payment they receive, rewarding yield-seeking investors for taking the increased risk. Below even the non-investment grade tranches (and a cash reserve fund to cushion against losses) there sits a non-rated or ‘equity’ layer which doesn’t receive a set coupon but instead represents a claim on all excess cash flows once the obligations for all other tranches have been met.

This layering and loss absorption provides significant structural protections for holders of the rated tranches. Realised losses on European structured finance transactions since 2009 have been exactly zero (and just 0.38% in the years prior). In particular, where an underlying loan backing an ABS deal defaults, it is not the equity tranche which takes the first hit, but the collateral that was backing that loan: for example, where an individual defaults on their residential mortgage, if the bank can recoup the value of the loan by selling the property then no losses will be incurred by the MBS.

Floating Returns – ABS bonds pay a floating rate income at some % margin above current cash rates. This means that, all else equal, they are bonds which actually benefit from higher interest rates. Where the underlying loans in the ABS portfolio pay fixed interest costs the ABS manager will enter into interest rate swaps to align the cash flows to each other.

Illustrative ABS example

Source: TwentyFour Asset Management.

The Attractiveness of ABS

ABS exposure is complementary to portfolios and offers attractive benefits over and above traditional fixed income:

• Higher yields – ABS normally offer a higher yield for a given risk level or maturity compared to vanilla government or corporate bonds. ABS investors can benefit from this ‘complexity premium’ that results from the comprehensive underwriting process and non-standard structuring.
• Inflation/rate protection – Almost all European ABS is floating rate which means they have near-zero interest rate (i.e. duration) risk and should be far less volatile in rising interest rate environments compared to traditional fixed income.
• Flexibility – The granularity of ABS structures and tranches allows active ABS investors to pick and choose direct exposure to the areas of the market that are most attractive at any particular time. Investors can determine the exact risk level, asset type (mortgages/loans/credit cars etc.) and geography they want to invest in.
• Diversification – ABS structures are not simply existing risk exposures packaged differently; they provide direct exposure to consumer credit which investors typically can’t access in other parts of the traditional market. This provides for added diversification in portfolios and enhanced risk-adjusted returns.

Higher yields available on ABS (Yield-to-maturity)

Source: Bloomberg, Waverton. As at 3 June 2024.

ABS at Waverton

At Waverton we take advantage of the ABS market through two core holdings in closed-ended investments trusts which can access the most attractive, often illiquid, parts of the markets:

• Twenty Four Income Fund (TFIF) – Closed-end fund investing in the European ABS market including 28% in non-rated tranches. Current mark-to-market yield of 13% and targets an annual dividend of 8p (although we believe could be materially higher). Sectors: 48% RMBS, 37% CLO, 15% other.
• Fair Oaks Income (FAIR) – Closed-end fund investing in US and European CLOs. 84% of the portfolio is subordinated (i.e. non-rated CLO equity). Current weighted average yield of 14%.

Users of Waverton’s MPS will benefit from the performance of both through the Real Assets Fund, one of the four MPS buildings blocks, which holds a combined 2.8% in the vehicles. Within our multi-asset fund range, the Multi-Asset Income Fund also holds both TFIF and FAIR, while the Multi-Asset Growth, Balanced, Cautious and Defensive funds make use of open-end sister funds (TwentyFour Monument and Fair Oaks Dynamic).

Risk-rating exposure comparison

Source: TwentyFour Asset Management, Fair Oaks Capital, Waverton. As at end-March 2024.

Conclusion

While absolute yields have rebounded in response to central bank rate hiking cycles, credit spreads have tightened to levels only seen a handful of times since the Global Financial Crisis. In this context we find ABS as an attractive source of value given the consistent ‘complexity premium’ providing higher spreads than those from vanilla corporates. Additionally, where interest rates remain stubbornly high and expected central bank rate cuts are pushed back towards the summer or later, ABS bonds continue to clip high ‘cash-plus’ income. Therefore, we feel that there are extremely attractive diversification and portfolio enhancement benefits available to those investors able to access this non-standard asset class.

Bloomberg Global Agg Corporate Average OAS

Source: Bloomberg, Waverton. As at 3 June 2024.

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