Author: Calvin Davies, Head of ABS and Covered Bonds at NN Investment Partners
Calwin Davies |
The Floating Rate nature of high quality European Asset Backed Securities (ABS) is attracting increasing interest from investors concerned about the potential impact of any “normalisation” of interest rates and inflation as European Central Bank (ECB) “tapering” draws closer.
Debt markets face a number of difficult challenges this year, with investors bracing themselves for future tapering by the ECB, while inflation and interest rates are expected to rise in the US and in Europe over the longer term.
However, ABS, which are bonds backed by collateral such as residential mortgage loans, consumer loans, loans to small- and medium-sized corporates, etc., are attracting increasing levels of interest as they offer investors something of a “safe haven” because their floating rate nature provides protection against rising interest rates and inflation.
In the present market environment, where the yields on many fixed income asset classes are low and in some cases even negative, investors are increasingly considering European ABS as an attractive alternative to more traditional fixed income categories. Many investors are concerned about the “normalisation” of interest rates and inflation in the medium term and, in order to mitigate the impact of this, they are seeking exposure to good quality investments with a floating interest rate, such as European ABS.
Despite the consistently strong fundamental performance of ABS in Europe, the asset class is still either unloved or unknown by certain segments of the investor universe. This is one of the reasons why it still offers a yield pick-up compared to more traditional fixed income asset classes with a similar risk profile. The yield pick-up, together with the floating rate coupon, is proving to be an attractive combination in the current market environment. ABS spreads have been moving tighter, but the asset class still offers attractive relative value versus similarly rated investments in other fixed income asset classes such as Sovereign Bonds, Corporate Bonds or Covered Bonds. The graphs below show generic yield comparisons in order to illustrate the difference in yield between ABS and other comparable asset classes.
Although issuance levels have not yet regained the levels seen before the Credit Crisis, the European ABS market has seen a number of positive developments in recent years as the industry has moved toward greater transparency and standardisation:
Also, there are initiatives by European regulators that are positive toward the asset class:
Nonetheless, investing in the ABS market requires specialist expertise and experience. ABS is a credit product, and investors are therefore subject to credit risk, as well as potential market/price volatility. Historical credit losses generated by European ABS have been very limited, and credit performance has been positive. Despite this, it is important to have a thorough understanding of the underlying pool of collateral, the business model of the originating mortgage bank/finance provider, and the structure of an individual transaction. Moreover, it is crucial to understand the dynamics involved in this particular part of the fixed income market.