Weaker consumer credit is heightening risks for asset-backed investors, who are coming off a very good year.
By Jeanne Burke
March 2001
Institutional Investor Magazine
Not everyone got killed in the market last year. Investors in asset-backed securities realized returns of 40 basis points over a strong-performing Treasury market. Capitalizing on an unexpectedly receptive audience, issuers of ABSs sold $220 billion in bonds in 2000, up from $194 billion in 1999 and an all-time high for the asset class.
An encore performance seems unlikely, though. Deteriorating consumer credit would put direct pressure on asset-backeds, especially lower-rated securities and those backed by “subprime” loans. Issuers create asset-backed bonds by packaging consumer loans - primarily car loans, credit card debt and home equity loans - and selling them to a legal entity that is remote from bankruptcy. This entity then carves the loans’ cash flows into bonds of various maturities and sells them to yield-hungry investors.
Says Dennis Kraft, senior vice president at Hartford Investment Management Co., which holds about $5 billion in asset-backed securities, “These securities are all consumer related, so there’s huge exposure there.” If consumers fall behind in paying their loans, the bonds backed by those loans lose some of their value. Worse yet, if consumers default on their loans in significant numbers, investors in lower-rated asset-backed bonds could suffer serious losses.
To minimize those risks, portfolio managers are looking for relatively solid issuers and prudently diversifying their portfolios. At the same time, they are scouring the market for opportunities in “headline risk,” which arises when negative news about an issuer or sector temporarily drives spreads to unsustainably wide levels.
“We’re staying with the highly liquid names, and we’re not extending out the yield curve unless it’s very stable. Generally, we’re being more conservative in our name selection,” says Maureen Svagera, senior partner at Harris Investment Management, which holds some 10 percent of its $5.5 billion fixed-income portfolio in ABSs. As the economy slows, most investors, like Svagera, see the best value in the single-A- and double-A-rated subordinate tranches sold by well-known auto-loan and credit card issuers.
Asset-backeds benefited tremendously during the second half of last year from a flight to quality within the bond market. As the Nasdaq composite index plummeted and the economy faltered, many institutional investors grew concerned about corporate credit quality. They decreased their exposure to corporate bonds while increasing their allocation to asset-backeds, which are more insulated from corporate credit risk because they are sold by separate, bankruptcy-remote entities. ABS spreads tightened dramatically over the second half as a result. Although ABSs outperformed Treasuries, investment-grade corporate bonds underperformed Treasuries by 449 basis points, according to Lehman Brothers. As ABS yields dropped and corporate bond yields rose, big companies like Ford Motor Co. chose to sell more bonds in the asset-backed market.
This year, though, some investors who sought refuge in ABSs in 2000 may reverse direction, lured by higher yields in the corporate bond market.
As he surveys the landscape, Kraft is paying close attention to credit quality. “We’re coming off a ten-year improvement in consumer credit,” and the end of that cycle may be in sight, he believes.
Kraft keeps the bulk of his holdings in the main ABS sectors. One third of his portfolio is in credit card securities. During the past three years, he’s begun to dabble in rate reduction bonds, and they now make up about 5 percent of the firm’s ABS holdings. These securities are essentially backed by the tariffs that utilities attach to consumers’ monthly bills to pay for the utilities’ stranded costs. Typically rated triple-A, rate reduction bonds made up less than 2 percent of new ABS issuance last year, but that percentage is expected to increase in 2001.
Occasionally, court challenges to the tariffs arise to create headline risk, and spreads on rate reduction bonds quickly widen. Kraft monitors those movements carefully. “In the last year or so, if they widened out to LIBOR plus 25 basis points, we’d buy, and when they tightened to LIBOR plus 15, we’d sell,” Kraft says.
The California power crisis that erupted in December provided an especially attractive opportunity to some investors. As many pulled back from the entire sector, and particularly from bonds issued by the California utilities, spreads on these securities almost immediately widened to 40 to 50 basis points over LIBOR. “We thought that the risk of the underlying security would remain at the triple-A level because the right to receive the tariffs is held by a special-purpose entity that is divorced from the utilities. What it would take [for the bonds to fail] is for people to no longer receive power,” Kraft says.
Adds Hartford vice president and ABS researcher Jon Prestley, “It really is a litmus test of whether you believe in the underlying theory of asset-backed securities - that is, the bankruptcy remoteness.”
Kraft notes that being able to take a six-month view of the rate reduction bonds is an advantage for Hartford that some investors, who report performance on a daily or weekly basis, do not enjoy. Hartford, which invests in ABSs for both its internal and external accounts, targets durations of about three years. Because the portfolio is large, Kraft explains, investments can be “laddered throughout the curve” to achieve a balance between longer maturities and shorter ones.
Harris’s Svagera uses rate reduction bonds to diversify the firm’s asset-backed holdings, which make up 15 to 17 percent of the firm’s two bond funds. She tends to buy ABSs with maturities of three years or less. But Svagera sees value in new deals, such as New Jersey’s $2.5 billion January bond offering, as well as in secondary market securities. “This will be the last big year of issuance,” she notes. As issuance tapers off, she believes, rate reduction bonds should benefit from their relative scarcity.
The manufactured housing sector generated more than its share of headline risk during the past year, when Conseco, the biggest issuer of manufactured housing securities, reported steep losses at its Conseco Finance Corp. (formerly Green Tree Financial Corp.) and put the lender on the block. Concerned about the company’s loan underwriting standards and the impact of its troubles on its outstanding securities, investors dumped the bonds, and spreads widened drastically. Some investors have filed suit against Conseco, alleging that company executives falsified loan delinquency information.
Many ABS investors have switched into the home-equity-loan sector, which has been coming out of a consolidation period. “We’ve been getting back into manufactured housing lately,” says Stephen Finkelstein, fixed-income portfolio manager and head of ABS strategies at J.P. Morgan Fleming Asset Management, which holds about $8.5 billion in asset-backed securities.
Hartford is also eyeing the manufactured housing sector again, though so far it hasn’t put down any stakes. In Kraft’s view, home-equity-loan securities have been a good buy, as ContiFinancial Corp., United Companies Financial Corp. and Southern Pacific Funding Corp. have filed for bankruptcy in recent years and other issuers have come perilously close to it. Servicing on their loans was transferred to stronger entities, leaving the ABS deals unharmed but undervalued because of the headline risk. “You might have triple-B risk that is trading like a single-B,” Kraft says.
ABS investors are picking up a smattering of lower-rated deals to boost their yield. Many of the strongest credit card and auto loan issuers sell subordinate asset-backed securities with ratings of single-A or double-A that provide up to 20 bps of extra yield when compared with triple-A asset-backeds.
“We think that the spreads are attractive, and versus a typical single-A corporate issuer, the credit quality on the asset-backed is higher based on history - there’s less chance of a downgrade,” explains Robert Auwaerter, principal and senior fixed-income portfolio manager at Vanguard Group, which holds about $1.7 billion in ABSs in its short- and intermediate-term corporate bond funds. That figure represents about 20 percent of Vanguard’s total $9.7 billion corporate bond portfolio. Credit card and auto loan securities make up the bulk of Vanguard’s holdings, though it also invests in rate reduction bonds and other short-term ABSs.
Hartford likes subordinate tranches, too, particularly auto loan securities. Ford, one of Kraft’s favorites, came to the ABS market four times last year, after news of the Explorer recall in August caused its corporate bond yields to rise from 175 to 235 basis points through December. Thanks to the company’s solid loan underwriting standards, Ford’s subordinate tranches are often upgraded over time, which translates into easy profit for investors holding those securities. “It’s a good bread-and-butter play in both the primary and secondary markets,” Kraft says.
Though the junk bond market has been thriving, most ABS investors have been selective in buying triple-B and non-investment-grade asset-backeds, and that trend is likely to persist. Says Harris’s Svagera, “If the economy is suffering, as indicated by the most recent Fed move, we will probably see an increase in defaults in these portfolios.”
Triple-B and below-investment-grade subordinate ABSs look cheap, she says, and she thinks they’ll stay cheap for a while. “These issues don’t have the potential to outperform until the economy bottoms out.” And Svagera doesn’t think that will happen any time soon.
