Esoteric ABS: Learning Curve May Be Worth Possible Yield

By Paul Norris

Insurers are all too familiar with the difficulties of generating portfolio income in this low interest rate environment. Fortunately, there is a fixed-income asset class that may offer greater yields than many types of other similarly rated debt, and it’s within a structure many insurers already know well: the asset-backed security. Although this ABS subset is backed by assets some investors may not be familiar with, the learning curve might be worth the effort.

Since mid-March, the “esoteric ABS” asset class has maintained a steady yield advantage over similarly rated debt securities that are staples of insurance portfolios, such as government and corporate bonds. They have also outperformed more traditional ABSs, which are backed by non-mortgage assets such as auto loans, credit cards and receivables. Esoteric ABS collateral, such as commercial jets, shipping containers and consumer loans, may be new to insurers, but the investment process is no different than for traditional ABS.

The year 2020 was a volatile one for all asset classes. And while spreads (the difference in yields between a bond and a U.S. Treasury of similar duration) for most fixed-income assets have recovered from their mid-March wides, when pandemic fears overwhelmed investors, esoteric ABS spreads have remained wider. This is likely due to economic conditions as well as investor hesitation. Therein lies the potential opportunity, and one we think many insurers should consider.

The ABCs Of ABSs

First, let’s quickly revisit how a structured product like the ABS works.

A deal sponsor provides a diversified array of loans/leases (which are generating principal and interest payments) to an investment bank. The investment bank structures the cash flows of these loans/leases into securities of varying levels of risk and offers them to investors. The cash flows backing the securities are expected to fulfill the ABS’s obligations and drive the rating agencies’ grades for the securities.

While the financial crisis of 2008-2009 caused many to reconsider asset-backed securities, the ABS market has seen several structural improvements in the interim. Rating agencies are operating with greater transparency, and securities are offering improved underwriting as well as greater credit enhancements for stronger investor protection. New structures are smaller and simpler, and issuers must now retain a portion of all new deals. This helps to better align their interests with those of investors.

ABSs (including esoteric) offer portfolios additional diversification, as they are backed by a variety of assets not found in traditional fixed-income strategies, a high degree of liquidity, a low history of defaults, and a favorable capital-charge profile for insurers. Add in the competitive yields, and ABSs appear to be an asset class that insurers should consider.

Esoteric ABS Spreads Remain Wider As Market Rebounds

Many investors had already become more comfortable with the esoteric ABSs by late 2019, and their tighter spreads were limiting their appeal versus corporates and non-agency mortgages. When the pandemic began in the U.S. in early March, spreads of all types of debt securities quickly widened to levels not seen since the financial crisis. As esoteric asset-backed securities are less mainstream, their spreads were wider still; senior airline ABSs reached a sky-high 14%.

ABSs (including esoteric) offer portfolios additional diversification, as they are backed by a variety of assets not found in traditional fixed-income strategies, a high degree of liquidity, a low history of defaults, and a favorable capital-charge profile for insurers.

However, conditions completely reversed within two weeks. On March 23, 2020, the Federal Reserve announced its programs to support broad swaths of debt, and within 48 hours many corporate and traditional ABS security yields were tighter by as much as several hundred basis points. While the Fed programs offered support for corporate and much of ABSs, they didn’t include esoteric asset-backed or non-agency mortgage-backed securities. The general retightening of spreads has esoteric ABS yields back to more palatable — but still wider — levels, presenting opportunities for investors seeking yields over those of similarly rated corporate bonds.

A Changing Landscape For Collateral

A full understanding of the esoteric ABS also requires an understanding of the evolving market dynamics for the underlying assets.

The used-car market offers an example, as it is largely financed by nonprime auto loans. Used-car prices plummeted in early March, but that all changed once the pandemic hit as consumers sought to buy vehicles to move farther from cities and avoid subway systems and ride-hail services. The demand drove used-car prices to all-time highs in July. Hertz, which uses fleet-sale proceeds to pay bondholders, experienced this spike firsthand: it sold 40,000 cars in June at 10% above book value, good for Hertz as well as for subprime loan investors.

However, uncertainty still dominates investor thinking and will likely drive yields in the months ahead for esoteric sectors. Conning expects airline lease yields to remain wide until business travel resumes at stronger levels, which may be years away. Railcar yields are also subject to U.S. economic growth, as many goods are shipped by rail, while shipping containers are reliant on global gross domestic product conditions. Consumer spending remains under pressure as well as unemployment is high, and conditions are cloudy for further government stimulus, the production of vaccines and the patience for social distancing.

In the near term, Conning expects to see growing government debt levels and a continuation of lower interest rates, supporting our view that ABSs may help investors find greater yields. Strong investment discipline and experience in evaluating structures and collateral will likely be of even greater value.

Understanding “Esoteric”

Conning’s view is that the market for esoteric ABSs offers compelling opportunities for investors seeking greater yields against more traditional fixed-income securities of similar quality and duration. Spreads remain wider now than before the pandemic, but we believe there are investments that are worth the risk — although we encourage investors to work with asset managers well experienced in the asset class.

The term “esoteric” to some suggests an asset class that is difficult to understand, but our client experience suggests that it is more about their being less familiar with the collateral. Just because securities offer higher yields than similarly rated debt does not necessarily mean they are less safe. They do present different risks, but working with an experienced asset manager should help investors understand what those risks are and weigh the opportunities.