alternative viewthe abs market differentiates between two types of structures for paying out the...
TRANSCRIPT
Intended exclusively for professional clients/institutional investors and not for retail clients.
Alternative view
By Niek Swagers
June 2018
ABS under the microscope
2
ABS under the microscope Asset-Backed Securities (ABS) offer an opportunity for investors to enhance the return and diversify the risk of their
portfolio. This white paper provides insights into this asset class. What are ABS, how are ABS structured and what
are the characteristics of the European ABS market in particular? This analysis can help investors to better
understand the asset class, including its opportunities and risks.
What is an ABS and how is an ABS structured? ABS are loans (‘securities’) that are covered (‘backed’) by a specific
collateral (a pool of ‘assets’). The underlying loans, such as residential mortgages or credit card loans, are often split
into different risk tranches. The losses on the pool of assets are first absorbed by the higher-risk tranches but these
tranches also have a higher return potential. The availability of the characteristics of the underlying loan portfolio
makes it possible for investors to perform in-depth risk analyses. This gives investors the opportunity to select an ABS
that corresponds with their risk and return preference.
The risk profile of ABS is characterized by their variable interest payments (floating rate coupons). This makes the
interest rate risk of an ABS substantially lower than for sovereign or corporate bonds. Depending on the overall
interest rate hedging policy, the short duration can make ABS an attractive investment in a scenario of rising interest
rates. Another feature of an ABS is that the credit risk is not caused by countries or companies, but predominantly by
consumers. Because of this exposure to consumer risk, ABS offer an attractive opportunity for risk diversification
within the fixed income portfolio.
The euro-denominated ABS market is very diverse in terms of the underlying collateral. For this reason, the different
market segments are defined according to the type of underlying loans. The majority of the market consists of
Residential Mortgage-Backed Securities (RMBS) and Consumer ABS (securities backed by car loans, credit card loans
or student loans). The United Kingdom, Spain and Italy are strongly represented as issuers of European ABS and most
securities have a high rating (from A up to AAA). However, within segments of the market the distribution over
countries and ratings differs strongly. This helps to create an ABS portfolio that is well-diversified over segments,
countries and ratings and that meets the risk-return preferences of an investor.
3
Introduction to ABS ABS are loans (‘securities’) that are covered (‘backed’) by a specific collateral (a pool of ‘assets’). In general, the
underlying pool of assets are loans from one category and one jurisdiction, for example residential mortgages, car
loans, student loans or credit card loans. These underlying loans are stand-alone harder to sell to another buyer
because the loans can vary with regard to format, interest rate and other agreements that have been made between
the provider of the loan and the borrower. Banks provide the underlying loans to lenders, but may want to sell them
to other investors in order to free up capital on their balance sheet.
The process of combining loans and issuing one or more new securities is called securitization. It is also possible to
split these new securities and create different risk tranches in the process. The risk of a tranche is predominantly
determined by the degree of protection for losses, in other words the degree of credit risk. The losses on the
underlying pool of assets are first absorbed by the higher-risk, or subordinated, tranches. This creates a lower credit
risk for the lowest risk, or ‘senior’, tranche. Rating agencies are able to give a credit rating for different risk tranches
of an ABS based on the large set of historic performance data of the underlying collateral. These risk tranches make
the underlying loans more attractive for investors because they can buy the tranche that suits their specific risk-return
preferences.
Credit crisis
The credit crisis of 2008 gave ABS a bad name. The mortgage market in the United States was said to be one of the
main causes for the credit crisis. A large proportion of the mortgage loans that were granted in the US before the crisis
were sold to investors as ABS. A significant part of the underlying mortgages were related to consumers with a low
income, or even no income at all. These mortgages are typically referred to as subprime mortgages.
At the time, the rating agencies underestimated the risk of these subprime mortgages. First of all, the decline of the
housing market turned out to be stronger than expected . Moreover, it turned out that the willingness and the
possibility of homeowners to pay, was also significantly lower than estimated. Contributing to the subprime mortgage
crisis was the fact that homeowners in the US could simply hand over the keys of their house to their bank in order to
free themselves from their mortgage-payment obligations. When the value of the house is lower than the value of the
loan, this is an attractive feature for homeowners to release themselves from their mortgage debts. As a consequence,
these specific US subprime mortgage-backed securities suffered large losses, because many underlying mortgage
loans defaulted.
ABS were also often included in money-market-type products due to their strong credit quality and the variable
interest payments. After the rating downgrades of US subprime ABS, many forced sales of other ABS took place as
well. The low liquidity of the overall financial markets and the large number of forced sales resulted in a decline in the
value of European ABS. But the credit losses on European ABS remained very limited due to the high quality of the
underlying loans (the collateral) of these European ABS. Despite the drop in value, interest payments and repayments
on the European ABS investments continued. After a while, the prices of the European ABS therefore recovered.
Structure of ABS An ABS is a combination of underlying loans into one new loan, which in turn is split up into different risk tranches.
When banks provide a loan to consumers and companies, they are normally limited in their ability to provide new
4
loans. In order to free up capital, a selection of outstanding loans of a similar type can be combined and then resold
as new packages of loans (i.e. an ABS) to investors.
ABS are created through a process called securitization. Individual loans are brought together by the lender in a Special
Purpose Vehicle (SPV), which is established specifically for this goal. In practice, this happens by selling individual loans
that are on the banks’ balance sheet to the SPV. The capital that is required for the purchase of the loans by the SPV
comes from the participants in the ABS (the investors). The SPV is therefore the owner of the ABS. Future cash flows
are no longer owned by the original provider of the loans (the bank) but by the investors in the ABS. The risk and
return of the underlying loans are therefore passed on by the bank to the ABS investor.
Figure 1: Illustration of the cash flows of an ABS with mortgage loans as collateral.
Pass-through and pay-through
The ABS market differentiates between two types of structures for paying out the coupons and loan repayments (cash
flows) on the underlying assets to the ABS investors: a pass-through structure or a pay-through structure.
In a pass-through structure, every bond represents a proportional share in the underlying pool of assets. In this case,
investors have the right to a proportional part of the cash flows that come from the underlying portfolio. The pass-
through structure issues only one type of bond whereas a pay-through structure issues multiple types of bonds. These
different bonds within the same ABS structure are called ‘tranches’. Tranches can differ in their creditworthiness
(senior, mezzanine, equity), interest compensation, maturity profile, etc.
Bank
Special
Purpose
Vehicle
Investor
Mortgage loans (incl.
collateral)
with interest payments
Money
ABS bond with interest
payments
Money
Borrower
Interest payments
(with collateral) Money
5
Figure 2: Illustration of a pass-through structure and a pay-through structure.
Distribution of the risks and returns of a pay-through ABS
The SPV typically issues different ABS bonds that vary strongly in their risk and return profile. Often, the goal is to issue
a senior tranche with an AAA rating. In order to achieve this, so-called mezzanine tranches with a subordinated
position (and therefore a lower rating) are also issued, as well as an equity or first-loss tranche. In terms of yield
potential, the equity share has the highest return, but it must also absorb the first losses. These losses occur when the
underlying loans are not repaid. If the losses are so high that the equity tranche no longer has any value, then the
remaining losses are absorbed by the mezzanine tranches (the subordinated positions). Only when these mezzanine
tranches are fully written off, the senior tranche (AAA loan) needs to bear the residual losses. Therefore, the lower
the rating of a tranche, the earlier the tranche has to absorb losses.
The flip side is of course that the lower rated risk tranches offer a higher potential return (yield compensation).
Depending on the assessment of the possible losses on the underlying portfolio, the AAA tranche will be equal to 60%,
and in some cases even up to 92%, of the value of the underlying portfolio. Figure 3 illustrates the return of an risk
tranche as a function of the potential losses on the underlying pool of mortgages. Losses in the pool will affect the
return of the tranches following a so-called ‘waterfall’ that will hit the lowest rated tranches at first and the highest
rated tranches at last.
Figure 3: Illustration of a pay-through structure with mortgage loans as collateral.
ABS equity share
BBB ABS bond
AAA ABS bond
AA ABS bond
Possible loss on mortgage pool
Ret
urn
Pass-through
structure
Liabilities Investments
Mo
rtga
ges
Par
tici
pat
ion
s
AAA ABS bond
Pay-through
structure
Liabilities Investments
BBB ABS bond ABS equity share
AA ABS bond M
ort
gage
s
Par
tici
pat
ion
s
6
In fact, an ABS structure looks similar to that of a bank. A bank has shareholders who absorb the first losses. When
the shareholders are written off, the holders of subordinated bonds are next in line. When they are also written off,
the normal bondholders will follow, and ultimately the saving deposits can be liable too. The advantage of an ABS
investment, compared to an investment in a bank, is the availability of the characteristics of the underlying loan
portfolio for risk analyses. The balance sheet of an ABS is therefore often more transparent than banks’ balance sheet.
The individual underlying loans in the ABS can be analyzed one by one. Relevant data can include information about
the age, income and other debts of the borrower. Based upon on detailed information at the level of the individual
loans, it is possible to carry out solid research on the creditworthiness of an ABS.
Scenario analyses are used to determine under which scenarios an ABS is likely to meet its obligations for interest
payments and principal payoff. In the ABS market, the investor can thus make a well-informed choice about the
desired risk-return profile. For example, the investor can choose a safer investment by purchasing the AAA tranche,
but if the investor has a strong opinion on the underlying value and the expected economic scenarios, a lower-rated
tranche can also be selected. The potential return of this tranche is higher because this tranche will absorb potential
losses earlier. In this way, ABS investors can select the risk tranche that suit their specific risk-return profile.
Risk profile of ABS Investing in ABS entails a number of risks that often correspond to the risks of other fixed income investments.
Therefore, we will now focus on the typical differences in interest rate, credit, concentration and liquidity risk of an
ABS.
ABS are characterized by their variable interest payments (floating rate coupons). The maturity of the euro-
denominated ABS market with residential mortgage loans as collateral (i.e. residential mortgage-backed securities)
has been on average 4.68 years.1 The floating rate coupon is often the 3-month Euribor rate including a spread as
compensation for the credit risk.2 As a result of the quarterly update of the Euribor rate, an ABS has a similar short
duration. By contrast, sovereign and corporate bonds often have fixed interest payments (fixed rate coupons). This
makes the interest rate risk of an ABS substantially lower than for sovereign or corporate bonds. However, in
combination with interest rate swaps, ABS can be used as part of the interest rate hedging portfolio of institutional
investors such as pension funds and insurance companies.
Another feature of an ABS is that the credit risk is not caused by countries or companies, but predominantly by
consumers. For example, the degree to which a consumer is able to meet his or her mortgage obligations determines
the credit risk for an mortgage-backed security. The credit premium or spread above the Euribor rate provides
compensation for this credit risk. If the spreads for ABS rise, then the value of an ABS declines. The relative level of
the spread reflects the assumed credit risk of the ABS. Because of their exposure to consumer risk, ABS offer an
attractive opportunity for diversification within the fixed income portfolio, especially when the portfolio only consists
of sovereign and corporate bonds.
1 Barclays Capital Euro ABS Floating Rate Note Index, as of 31 December 2017. 2 In the ABS universe there are also underlying loans with fixed interest payments (fixed rate coupons). These are often converted into a variable interest payments by using interest rate swaps.
7
The euro-denominated ABS market has a relatively large exposure to southern European countries. Particularly, Spain
and Italy represent a large portion of the ABS universe. This can lead to a higher concentration risk. Compared to
government and corporate bonds, ABS have a higher liquidity risk, i.e. the risk that an investment cannot be quickly
bought or sold at a reasonable price. Although the European ABS market is smaller than the market for government
and corporate bonds, in practice the ABS market typically offers sufficient liquidity to trade fast. If we compare
mortgage-backed securities with direct mortgage investments, the liquidity risk of these mortgage-backed securities
are lower.
Characteristics of the ABS market The market for ABS is relatively large within the overall bond market. The market for investment-grade sovereign
bonds from the Eurozone had a size of around € 7,100 billion, and the market for investment-grade corporate bonds
from the Eurozone was around € 1,870 billion.3 The size of the outstanding euro-denominated ABS market (investment
and non-investment-grade) is around € 1,020 billion and can be divided into different subcategories.4
The ABS market is very diverse in terms of the underlying collateral. For this reason, the different market segments of
ABS are defined according to the type of underlying loan of the ABS.
The most important market segments in the euro-denominated ABS market are securities that are backed by:
• Mortgages to individuals: Residential Mortgage-Backed Securities (RMBS)
• Mortgages to companies: Commercial Mortgage-Backed Securities (CMBS)
• Loans to individuals (often for the purchase of a car): Consumer ABS
• Mix of different forms of underlying loans: Collateralized Debt Obligations (CDO)
• Loans to medium and small-sized companies (with collateral): Small and Medium Enterprise CLO (SME CLO)
Figure 4: Breakdown of the outstanding euro-denominated ABS market by sector, as of 31 December 2017. Source: AFME.5
3 Barclays Capital Euro-Aggregate Government Index respectively Barclays Capital Euro-Aggregate Credit Index, as of 31 March 2018. 4 AFME Securitisation Data Report 2017: Q4, via https://www.afme.eu/en/reports/Statistics/securitisation-data-report-q4-2017/. ABS from multinational and pan-European regions that are quoted in euros are included in these and other calculations in this white paper. 5 AFME Securitisation Data Report 2017: Q4, via https://www.afme.eu/en/reports/Statistics/securitisation-data-report-q4-2017/.
60%
5%
19%
10%
7%
European ABS market by sector
Residential Mortgage-Backed Securities (RMBS)
Commercial Mortgage-Backed Securities (CMBS)
Consumer ABS
Collateralized Debt Obligations (CDO)
8
The figure above shows the relative size of these five sectors. It shows that RMBS (ABS with residential mortgage loans
as collateral) account for the largest part of the market. This segment is much bigger than CMBS (ABS with mortgage
loans on commercial real estate as collateral). The market segment Whole Business Securities (WBS) is not shown in
this pie chart because WBS accounts for a very small portion (5%) of the ABS market and predominantly exists in the
United Kingdom.6
The next two pie charts show the breakdown of the euro-denominated ABS market by country and rating. Nearly 75%
of the market has a high rating (from A up to AAA). In the pie chart showing the country distribution, United Kingdom
is in first place. Spain and Italy, which are generally seen as riskier, are also strongly represented with a combined 25%
of the market. Large European countries such as Germany and France play a lesser role.
Figure 5: Breakdown of the outstanding euro-denominated ABS
market by country, as of 31 December 2017. Source: AFME.7 Figure 6: Breakdown of the outstanding euro-denominated ABS
market by rating, as of 31 December 2017. Source: SIFMA.8
An important part of the market for pay-through ABS is the Collateralized Debt Obligations (CDO) market. This includes
various market segments, whereby the differences are especially dependent on the type of debt that serves as the
underlying pool of assets for the CDO. Within this CDO category are Collateralized Loan Obligations (CLO),
Collateralized Bond Obligations (CBO) and Collateralized Mortgage Obligations (CMO), among others. In this market,
however, only CLO and CBO are normally placed under the category CDO, while CMO are often categorized in the
Mortgage-Backed Securities (MBS) market. When discussing the ABS market segments, we follow this market
convention.
6 WBS are securitizations whose interest payments are made from (future) cash flows from a company, business unit or a group of them. Unlike the other ABS market segments, this concerns the securitization of ‘operating assets’ instead of ‘financial assets’. Examples of such operating assets are future cash flows from airports, harbors, pubs or royalties. 7 AFME Securitisation Data Report 2017: Q4, via https://www.afme.eu/en/reports/Statistics/securitisation-data-report-q4-2017/. This data report is used for all other figures on the country distribution in this white paper. 8 SIFMA Europe Structured Finance Issuance and Outstanding, 2017 Q4, section ‘Europe Securitisation Outstanding’, via https://www.sifma.org/resources/research/europe-structured-finance-issuance-and-outstanding/. This data report is used for all other figures on the rating distribution in this white paper.
25%
14%
14%12%
8%
6%
5%
16%
European ABS market by country
United Kingdom
Netherlands
Spain
Italy
France
Germany
Belgium
Other
42%
16%
17%
4%
7%
14%
European ABS market by rating
AAA
AA
A
BBB
< BBB
No rating
9
For pay-through structures within the Consumer ABS sector, the classification by the Association for Financial Markets
in Europe (AFME) is used. CLO and CBO are listed in this case under Consumer ABS instead of under the CDO sector.
Please note that for CDO it is not necessary that the cash flows from the underlying assets exactly match the cash
flows of all tranches together. It is also possible that reinvestments of cash flows on the underlying pool take place
only during a specific period and that the CDO is amortized at a later time.
In addition to their exposure to United Kingdom, Consumer ABS and CDO have a relatively high exposure to countries
from southern Europe. In particular, the subcategories Consumer ABS and Small and Medium Enterprise Collateralized
Loan Obligations (SME CLO), loans to small and medium-sized companies, consist predominantly of loans from Spain
and Italy. In the appendices, we give a more detailed picture of the different subcategories and their underlying
distributions across countries and ratings.
Opportunities and risks of ABS ABS is an asset class with specific opportunities and risks for investors to consider when entering this market. The
figure below gives an overview of the identified opportunities and risks of investing in ABS. The appendices contain a
more detailed overview of the composition of the individual market segments in the euro-denominated ABS market,
including their unique opportunities and risks.
ABS with a floating rate coupon can, in combination with interest rate swaps,
be used as part of the interest rate hedge portfolio.
From a return perspective (spreads), ABS can be attractive compared with
sovereign and corporate bonds.
Due to their short duration, ABS are an attractive investment in a scenario in
which the interest rate rises (due to the floating rate coupon of ABS). This
also depends of course on the applied interest rate hedging policy.
ABS offer risk diversification in a fixed income portfolio, as the credit risk is
moreover based on consumers than on countries and companies (for
example in the case of Consumer ABS).
Opportunities
ABS are less liquid and are often viewed as more complex.
ABS have a reinvestment risk in the case of accelerated repayments.
Within specific segments of the market, ABS have a high share of non-
investment-grade loans or loans without a rating. This can be mitigated by
investing in ABS sectors with higher ratings.
The euro-denominated ABS market is characterised by a relatively large
exposure to countries such as Spain and Italy, but this risk can be mitigated
by investing only in tranches with a high rating.
Risks
10
Appendix 1 – Residential Mortgage-Backed Securities (RMBS)
RMBS are financial instruments backed by an underlying portfolio of residential mortgage loans as collateral. With a
market share of € 580 billion (around 60% of the total), RMBS account for the largest portion of the euro-denominated
ABS market, as shown in Figure 4. Through the process of securitization, this loan portfolio is turned into an investable
RMBS. RMBS are typically bonds of which the principal is paid off during its term. Also, almost all RMBS tranches have
a floating rate coupon.
The portfolio underlying a RMBS often contain a diverse selection of mortgages (e.g., spread over regions). This has
historically provided relatively stable returns. Figure 7 shows that the Netherlands is the biggest issuer of euro-
denominated RMBS, with a total of € 137 billion outstanding. United Kingdom takes a second place with € 119 billion,
followed by Spain with € 105 billion. The distribution by ratings in Figure 8 shows that almost half of all RMBS have an
AAA rating. Furthermore, around 85% are investment grade (rating of BBB or higher).
Figure 7: Breakdown of the outstanding euro-denominated RMBS
market by country, as of 31 December 2017. Source: AFME. Figure 8: Breakdown of the outstanding euro-denominated RMBS
market by rating, as of 31 December 2017. Source: SIFMA.
In Table 1, we show that characteristics of the euro-denominated RMBS market. We have used the data of the Barclays
Capital Euro ABS Floating Rate Note Index to represent the RMBS and the overall ABS universe.9 Within this universe,
almost all RMBS have a pay-through structure (using risk tranches). The average coupon and yield for RMBS are
respectively 0.18% and 1.19%. The average duration and maturity of the bonds in this segment are respectively 0.63
and 4.68 years. With respect to the rating, RMBS have an average rating of AA-, which is the same as the overall ABS
universe. Approximately 65% of the RMBS market relates to senior tranches (in contrast to subordinate tranches).
9 The Barclays Capital Euro ABS Floating Rate Note Index is a smaller universe than the AFME and SIFMA data that is used for the pie charts in this white paper. The reason for this, is that this index among others require an investment-grade rating (AAA-BBB), minimal remaining term, and minimal nominal value for every ABS. All information for this research pertains to the index, as of 31 December 2017.
24%
20%
18%
11%
9%
6%4%
7%
European RMBS market by country
Netherlands
United Kingdom
Spain
France
Italy
Belgium
Germany
Other
48%
18%
17%
2% 6%9%
European RMBS market by rating
AAA
AA
A
BBB
< BBB
No rating
11
RMBS market
Benchmark Rating Duration Maturity Coupon Yield Senior Subordinated
Total ABS Index AA- 0.67 4.20 0.26% 1.01% 70% 30%
RMBS AA- 0.63 4.68 0.18% 1.19% 65% 35%
Table 1: Key figures for the RMBS market within the Barclays Capital Euro ABS Floating Rate Note Index, as of 31 December 2017.
Source: Barclays Capital.
Due to the short duration, RMBS are an attractive subcategory in a scenario
of rising interest rates (due to the floating rate coupon). This depends of
course on the interest rate hedging policy that an institutional investor has
applied.
Typically provides relatively stable returns due to the diversity of the
mortgage pools.
Almost 50% of the RMBS have an AAA rating and 85% are investment grade
(≥ BBB).
RMBS is the largest ABS market segment, and therefore more liquid than
some other market segments.
Opportunities
Relatively large exposure to Spain, Italy and Portugal.
Diversification benefits are possibly limited due to already-existing exposure
to direct mortgage investments in the fixed income portfolio.
Risks
12
Appendix 2 – Commercial Mortgage-Backed Securities (CMBS)
CMBS are securities backed by an underlying portfolio of mortgage loans for commercial real estate as collateral.
CMBS is a relatively small part of the euro-denominated ABS market, accounting for € 45 billion (5%) as shown in
Figure 4. Like RMBS, CMBS are typically bonds whereby the principal is repaid during its term. Also like RMBS, the
majority of CMBS have a floating rate coupon. The portfolios underlying CMBS have a less diverse collection of
mortgage loans than RMBS. Like RMBS, CMBS often have no pass-through structure, but rather a pay-through
structure (using risk tranches). 10
Figure 9 shows that the largest issuer of CMBS is United Kingdom with € 35 billion. For euro-denominated CMBS, Italy
is the largest market with € 5 billion. This is followed by multinational pan-European countries with a total of € 4 billion
outstanding. The distribution of ratings in Figure 10 shows that a relatively small part of the market has an AAA rating,
23% has a credit rating lower than BBB (non-investment-grade) and even 16% is non-rated.
Figure 9: Breakdown of the outstanding euro-denominated CMBS
market by country, as of 31 December 2017. Source: AFME. Figure 10: Breakdown of the outstanding euro-denominated CMBS
market by rating, as of 31 December 2017. Source: SIFMA.
Table 2 shows that the average coupon and yield for CMBS are respectively 0.30% and 1.19%. The average duration
and maturity of this market segment are respectively 0.06 and 1.47 years, which is lower than the total ABS universe.
CMBS has a lower average rating of A and around 67% of the CMBS market consists of senior tranches instead of
subordinated tranches.
10 In the case of the Barclays Capital index for ABS quoted in pounds, around 2/3rd of the number of CMBS are in fact pass-through structures.
76%
11%
8%
3% 2%
European CMBS market by country
United Kingdom
Italy
Multinational
Germany
Other
8%
17%
23%
13%
23%
16%
European CMBS market by rating
AAA
AA
A
BBB
< BBB
No rating
13
CMBS market
Benchmark Rating Duration Maturity Coupon Yield Senior Subordinated
Total ABS Index AA- 0.67 4.20 0.26% 1.01% 70% 30%
CMBS A- 0.06 1.47 0.30% 1.19% 67% 33%
Table 2: Key figures for the CMBS market within the Barclays Capital Euro ABS Floating Rate Note Index, as of 31 December 2017.
Source: Barclays Capital.
Due to the short duration, CMBS are an attractive subcategory in a scenario
of rising interest rates (due to the floating rate coupon). This depends of
course on the interest rate hedging policy that an institutional investor has
applied.
Risk diversifier if the fixed income portfolio does not already contain direct
exposure to commercial mortgage loans.
Opportunities
Large exposure to United Kingdom. CMBS are often issued in British pounds,
making currency hedging often necessary for euro-denominated investors.
Relatively less stable returns due to a more concentrated pool of mortgages
(compared to the RMBS segment).
Almost 25% of the CMBS subcategory is non-investment-grade (< BBB rating).
Risks
14
Appendix 3 – Consumer ABS
Consumer ABS are backed by an underlying portfolio of all kinds of consumer loans. The most common consumer
loans in this category are car loans and credit card loans. Another well-known type are student loans. Figure 4 has
shown that the Consumer ABS segment accounts for € 179 billion (19%) of the euro-denominated ABS market.
Car loans have, just like mortgages, collateral and a repayment scheme. However, the repayment scheme of a car loan
is in general of a shorter duration and the borrowed amount is lower than that of mortgages. For these reasons, the
life of an ABS on car loans is, generally speaking, shorter than that of other ABS. Another difference with mortgages is
that the value of the collateral declines relatively quickly, whereas the collateral of mortgages generally rises in value.
ABS on car loans are normally created with a pay-through structure (using risk tranches).
In an ABS on credit card loans, the underlying portfolio consists of credit card receivables. The cash flows from
individual credit card receivables can fluctuate strongly from month to month. By combining thousands of credit card
receivables into one portfolio, a more moderate and stable cash flow can be created. A key feature of a credit card
loan is that it is a revolving credit, i.e. no standard monthly repayments are due. In addition, credit card loans by
themselves have no collateral. If debtors fail to pay, the recovery percentage is low. ABS on credit card loans are
generally as pay-through structured.
In the case of ABS on student loans (also called Student Loan ABS, or simply SLABS), the collateral consists of loans for
students to finance their education. There are two types of student loans, loans guaranteed by the government and
private loans without any form of guarantee. The latter type of student loan therefore has a higher interest rate. The
cash flow profile of SLABS are not very stable because students are limited in how much they can pay back during their
studies (and are often exempted from the obligation to pay back during their studies). So, the repayment speed will
often increase after completion of their studies. In the United States, SLABS make up a significant part of the ABS
market, but this is not the case in Europe. For the very limited number of SLABS within the euro-denominated universe,
a pay-through structure is used. These are all US loans from a single issuer (Sallie Mae, the largest private American
lender of student loans), whereby the ABS are quoted in euros. SLABS don’t have any direct collateral, but in the US it
is common that parents act as co-signer. This increases the chance of repayment in the event that students cannot
meet their payment obligations.
Figure 11 shows that the largest issuer for this type of ABS is Italy with a total of € 50 billion outstanding. United
Kingdom and Germany take a second and third place with € 37 respectively € 33 billion, followed by Spain (€ 20 billion)
and France (€ 18 billion). The rating distribution in Figure 12 reveals that 77% of the Consumer ABS have an rating
higher than or equal to BBB. Around 3% have a non-investment-grade rating, but 20% of Consumer ABS have no rating.
15
Figure 11: Breakdown of the outstanding euro-denominated Consumer
ABS market by country, as of 31 December 2017. Source: AFME. Figure 12: Breakdown of the outstanding euro-denominated
Consumer ABS market by rating, as of 31 December 2017.
Source: SIFMA.
Table 3 shows that the average coupon and yield for Consumer ABS are respectively 0.12% and 0.06%, which is lower
than for the total ABS universe. In this table, Consumer ABS have been broken down according to the three previously-
mentioned subcategories, whereby it is clear that they all contribute to the low average coupon and yield. The average
duration and remaining maturity of the three categories are respectively 0.07 and 1.97 years, which is lower than for
the overall ABS market. It is noteworthy that the remaining maturity of credit card and car loans is very short, while
that of student loans is much longer because student are often exempted for repayments during their studies. With
respect to ratings, this market segment has an average AA rating, which is slightly higher than the total universe.
Around 87% of the Consumer ABS market are senior tranches. Within the Consumer ABS market, all credit card ABS
come from United Kingdom; car loan ABS are strongly concentrated in France and (especially) Germany; and SLABS,
as noted earlier, all originate from the United States. These concentrations are largely caused by the limited number
of issues in these sectors.
Consumer ABS market
Benchmark Rating Duration Maturity Coupon Yield Senior Subordinated
Total ABS Index AA- 0.67 4.20 0.26% 1.01% 70% 30%
Consumer ABS AA+ 0.07 1.97 0.12% 0.06% 87% 13%
Car loans AA+ 0.07 1.47 0.12% -0.03% 85% 15%
Student loans AA -0.30 6.79 0.15% 0.75% 100% 0%
Credit card loans AAA 0.74 1.61 0.00% 0.15% 100% 0%
Table 3: Key figures for the Consumer ABS market (split into car loans, student loans and credit card loans) within the Barclays Capital Euro ABS
Floating Rate Note Index, as of 31 December 2017. Source: Barclays Capital.
28%
21%18%
11%
10%
11%
European Consumer ABS market by country
Italy
United Kingdom
Germany
Spain
France
Other
35%
13%21%
9%
3%
20%
European Consumer ABS market by rating
AAA
AA
A
BBB
< BBB
No rating
16
Due to the short duration, Consumer ABS are an attractive subcategory in a
scenario of rising interest rates (due to the floating rate coupon). This
depends of course on the interest rate hedging policy that an institutional
investor has applied.
Around 50% of this market segment has a rating higher than AA.
Diversification potential within a fixed income portfolio due to direct
exposure to consumer risk (instead of credit risk of governments and
corporates).
Opportunities
Relatively large (but spread-out) exposure to Italy and Spain.
Around 16% of the universe does not have a rating.
Credit card and student loans have no direct collateral, or the collateral
declines quickly in value.
Risks
17
Appendix 4 – Collateralized Debt Obligations (CDO)
CDO are ABS with a very diverse underlying loan portfolio. The asset pool may contain consumer loans, corporate
loans, bonds, credit derivatives, lease contracts and even other ABS. As noted earlier, this asset class can be divided
into Collateralized Loan Obligations (CLO) and Collateralized Bond Obligations (CBO), depending on the type of
underlying debt.
With € 97 billion outstanding, the CDO market covers around 10% of the euro-denominated ABS market, as shown in
Figure 4. The vast majority of this market is the CLO sector, which covers around 70%. We have not included in this
number the market segment of CLO with underlying loans to the medium- and small-sized enterprises (SME). We have
treated this so-called Small & Medium Enterprise Collateralized Loan Obligations (SME CLO) market as a separate
segment. Figure 4 shows that, with € 66 billion (7%), SME CLO is a smaller subcategory of the ABS market. There is
also a difference between ‘regular’ CDO and structured finance CDO. The latter category can be based on other ABS
(for example RMBS) or other CDO that are repackaged into new ABS. Especially since the credit crisis, the last category
is not frequently issued anymore.
Figure 13: Breakdown of the outstanding euro-denominated CDO
(excl. SME CLO) market by country, as of 31 December 2017.
Source: AFME.
Figure 14: Breakdown of the outstanding euro-denominated CDO
(excl. SME CLO) market by rating, as of 31 December 2017.
Source: SIFMA.
In addition to the scope of companies (SME’s versus larger companies), another difference is that larger companies
often have a rating, whereas SME’s are often not rated. When looking at the combined universe in Figure 13, it is
striking that 91% of the CDO market consists of CDO that are backed by a pool of loans from different countries and
that only 9% of the asset pools are solely linked to loans of a specific country, such as United Kingdom. If we look at
the rating distribution of the CDO market in Figure 14, we see that 26% of the market does not have a rating.
Figure 15 and 16 show the country and rating distribution of the SME CLO universe. In comparison to the overall CLO
market, the share of SME CLO with a AAA rating category is somewhat larger. This means that the creditworthiness of
the SME loans is less. There are also a few other differences between SME CLO and CDO. Because the underlying loans
91%
6%
2.8%
European CDO market (excl. SME CLO) by country
Multinational
United Kingdom
Other
44%
8%8%5%
9%
26%
European CDO market (excl. SME CLO) by rating
AAA
AA
A
BBB
< BBB
No rating
18
of an SME CLO come from one single country, it is easier to see which countries play an important role in the SME CLO
market. Belgium, Spain and Italy occupy the first three places with € 16 billion, € 13 billion respectively € 12 billion.
This means that these three countries account for as much as 62% of the overall SME CLO market. Southern Europe,
consisting of Spain, Italy, Greece and Portugal, accounts for around 53% of the market.
Figure 15: Breakdown of the outstanding euro-denominated SME CLO
market by country, as of 31 December 2017. Source: AFME. Figure 16: Breakdown of the outstanding euro-denominated SME CLO
market by rating, as of 31 December 2017. Source: SIFMA.
24%
20%
18%
9%
9%
8%
6%6%
European SME CLO market by country
Belgium
Spain
Italy
Greece
Germany
United Kingdom
Portugul
Other
22%
13%
19%
2%
11%
33%
European SME CLO market by rating
AAA
AA
A
BBB
< BBB
No rating
Possibility for extra return with respect to government and corporate bonds
without having to make any sacrifice with regard to credit ratings (via AAA
and AA tranches).
Underlying loans of CDO are, in most cases, spread over many countries and
therefore diversified by themselves.
SME CLO offer risk diversification potential in the fixed income portfolio
through their exposure to medium- and small-sized companies.
Opportunities
Large exposure to Italy and Spain in the case of SME CLO.
Around 25% of the CDO market and 31% of SME CLO market have no rating.
With arbitrage CDO, there is a possible conflict of interest between the
sponsor of the CDO that invests in the equity tranche and the investors in the
more senior tranches.
Risks
19
About the author
Niek Swagers is a consultant in the Investment Solutions team of Aegon Asset Management. In this role he helps
institutional investors to shape their investment policy and ensure it matches their goals, ambitions and risk appetite.
Acknowledgements
The author would like to thank the Investment Strategy team of TKP Investments and Herialt Mens of Aegon for their
research on Asset-Backed Securities, which forms the basis for this white paper. Furthermore, he extends his thanks
to Egbert Bronsema and David van Bragt for their contributions, which resulted in this final white paper.
About the Investment Solutions Center
The Investment Solutions Center of Aegon Asset Management is the knowledge hub for investment strategy solutions.
Various experts of Aegon Asset Management collaborate on research in areas such as balance sheet management,
regulatory impact, capital optimization and Asset-Liability Management. The joint knowledge and expertise is used to
support clients with research insights and suitable solutions.
More information
Frank Drukker, Sr. Business Development Director
Aegon Asset Management Netherlands
T. + 31 (0)6 10 13 28 25
20
Important Information: This communication is provided by Aegon Asset Management as general information and
is intended exclusively for Institutional and Wholesale investors as well as Professional Clients as defined by local
laws and regulations.
This document is for informational purposes only in connection with the marketing and advertising of products and
services and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the
solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction
where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s)
at the time of publication and are subject to change without notice. The research taken into account in this document
may or may not have been used for or be consistent with all Aegon Asset Management investment strategies.
References to securities, asset classes and financial markets are included for illustrative purposes only and should not
be relied upon to assist or inform the making of any investment decisions.
The information contained in this material does not take into account any investor's investment objectives, particular
needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not
be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a
representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon
information in this material is at the sole discretion of the recipient. Investors should consult their investment
professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or
implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated
entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of
any applicable U.S. federal or state law or regulation. By receiving this communication, you agree with the intended
purpose described above.
Past performance is not a guide to future performance. All investments contain risk and may lose value. An issuer
of bonds may be unable to make payments due to the client’s managed account (known as a default). The value of
bonds may fall as default becomes more likely. Both default and expected default may cause the account's value to
fall. Investment grade bonds generally offer lower returns because of their lower default risk in comparison to high
yield bonds which generally offer a comparatively higher return due to the increased risk of default. Investing in
distressed loans and bankrupt companies are speculative and may be subject to greater levels of credit, issuer, or
liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be
engaged in restructurings or bankruptcy proceedings. The value of real estate and portfolios that invest in real estate
may fluctuate due to losses from casualty or condemnation, changes in local and general economic conditions, supply
and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.
Structured Products (such as ABS, MBS and CLOs) are complex instruments typically involving a high degree of risk and
may not be suitable for all investors. The market value of these instruments may be affected by changes in economic,
financial, and political environment (including but not limited to spot and forward interest and exchange rates), as
well as market, maturity and credit quality of the issuer. The credit quality of a security or group of securities does not
ensure the stability or safety of the overall portfolio.
Aegon Group companies utilize Aegon Asset Management as a brand name to market their asset management
products and services. Aegon Asset Management group companies includes the advisory services performed by
various affiliates or their investment advisory business units and joint ventures. Aegon Asset Management is
comprised of the following global entities: Aegon AM US, Aegon Real Assets, Kames Capital plc, Aegon Investment
Management BV Aegon Asset Management Asia LTD, Aegon Asset Management Central and Eastern Europe (AAM
CEE), Aegon Asset Management Pan-Europe BV, TKP Investments BV and Aegon Asset Management Spain along with
21
joint-venture participations in Aegon Industrial Fund Management Co. LTD, , La Banque Postale Asset Management
SA, Pelargos Capital BV, Saemor Capital BV.
This communication may be issued by the following entities:
Kames Capital plc (Kames) is authorised and regulated by the Financial Conduct Authority and is additionally a
registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon
Investment Management B.V. (AIMBV) and TKP Investment B.V. (TKPI) are registered with the Netherlands Authority
for the Financial Markets as a licensed fund management company. Aegon Magyarország Befektetési Alapkezelő
Zártkörűen Működő Részvénytársaság (AAM CEE) is registered with the National Bank of Hungary as a licensed fund
management company. On the basis of their fund management licenses these entities are authorised to provide
individual portfolio management and advisory services. Aegon Asset Management Pan Europe B.V. (AAM PE) is an
appointed introducer for Kames Capital plc, Aegon Investment Management B.V. and TKP Investments B.V. (Aegon
Asset Management manufacturing entities) currently located in Germany, Spain and Japan. AAM PE does not operate
in the Americas. Aegon USA Investment Management, LLC (“Aegon Asset Management US”) and Aegon USA Realty
Advisors, LLC (“Aegon Real Assets US”) are both US SEC registered investment advisers. Aegon Asset Management
US is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC)
and is a member of the National Futures Association (NFA). Aegon Asset Management (Asia) Limited is licensed by
the Securities and Futures Commission of Hong Kong to provide services in securities dealing and securities advising.
Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of
this report without the prior written consent. ©2018, Aegon Asset Management.