Challenges remain but US looks forward to a better year
Although slowing loan origination is likely to lead to lower issuance of securitized products in the US, GlobalCapital’s survey of market participants shows some confidence that the worst of the volatility is over. But eyes will remain glued to the Federal Reserve for clues as to how conditions evolve. By Ayse Kelce.
After a record-breaking 2021 for issuance volumes, it was always going to be hard for the US securitization market to keep up the pace in 2022. And although constant dealflow demonstrated that structured finance is a largely resilient financial product, multiple headwinds slowed issuance, widened spreads and decreased investor demand across all asset classes.
There are recessionary fears in the air, which could be particularly damaging for the consumers that underpin much of the asset backed market. But it was rising interest rates, above all, that sent funding costs far higher. For 2023, this remains the foremost concern of market participants.
Half of the respondents to GlobalCapital’s survey believe that interest rate rises will be the most important factor determining securitization market activity, with more than 20% choosing US inflation — a related figure.
There is little expectation for a change in the rates picture early in 2023. That doesn’t mean the year won’t have a busy start, but it does mean a potentially challenging one. For issuers who have been avoiding the securitization market recently, January might be the month to get deals done.
“You may see a flood of issuance because people need to get stuff done,” Joseph Lau, chief operating officer at Lord Capital, tells GlobalCapital. “It has the potential to be pretty nasty, but that kind of cleans up the system.”
Large locked-in portfolios that haven’t been securitized yet would eventually have to come to the market, even though the pricing might not be ideal, Lau says. He adds that he has had many conversations since June in which issuers had been told to come to market, but some didn’t, afraid of wide spreads. Now, their assets are “totally mispriced”, and a lot of that new issue volume is going to have to come through in the first quarter of 2023.
Overall, market participants are closely monitoring the US Federal Reserve’s next moves. The biggest question in investors’ minds is whether the interest rate increases can be managed without too much damage to the economy.
“If the Fed is able to orchestrate a soft landing, then I think you can see a situation where spreads generally are tighter,” says Philip Armstrong, senior portfolio manager at Invesco. “And when that happens, the basis between the riskier portions of the market and the less risky portions of the market tend to compress. That’s the optimistic scenario.”
However, in a more pessimistic scenario where the Fed can’t contain inflation and continues to raise rates above today’s expectations, “that really will have an impact across fixed income”, Armstrong says.
Volatility to decline
Rate increases haven’t only been making deals more expensive for issuers. They have also been creating considerable market volatility, which means both issuers and investors are not clear about the best times to buy or sell.
Especially in the second half of 2022, this dynamic has caused issuers to hold off, while investors prepared for 2023, when they hope to find calmer waters. Yet there is some hope that, while rates might remain elevated, the securitization market can at least deal with them in a better fashion.
Some 18% of the survey participants say that they expect volatility in the US securitization market to decrease considerably, 36% say it will “somewhat” decrease; and 21% say it will stay the same. Only 3% expect the market to become more volatile.
“A lot of market participants have difficulty judging how to respond,” says Karlis Ulmanis, a portfolio manager at DuPont Capital. “And I think next year, even if rates continue to go up, the volatility will go down because market participants will be used to this kind of scenario.”
This is perhaps reflected in spread expectations, with survey respondents showing a slight bias towards expecting tighter spreads in 2023 versus 2022 across all securitized products asset classes.
Not that life will be easy. “While the asset backed markets remain open and functioning for many issuers, we expect certain segments of the market to remain dislocated next year,” Cory Wishengrad, head of fixed income at Guggenheim Securities, tells GlobalCapital.
He adds that navigating the market would require a lot of “structuring expertise”, especially for debut issuers.
Issuance and consumer health
Indeed, despite hopes for lower volatility and lower spreads, market participants generally predict lower deal volumes in 2023, with most respondents believing that RMBS, CMBS and CLO issuance will decrease.
The exception is ABS, where respondents largely expect issuance volume to remain close to 2022 levels. This could be a result of the broader economic slowdown.
“I would think that we generally will end up seeing a bit lower total gross issuance in 2023 than in 2022 just as a result of less loan origination, a slowing economy and higher interest rates,” says Armstrong at Invesco.
Although loan origination might be lower, existing loans weighing on issuers’ balance sheets might eventually find their way into the market. One common perception is that asset classes that are directly affected by consumer health are in a more fragile position going into 2023. Indeed, more than 58% of the survey respondents say that ratings on ABS and RMBS transactions will see more downgrades.
“I think delinquencies will be going up, especially for asset backed collateral,” Ulmanis says. “Consumer health will come into play a lot with ABS but also with RMBS. With higher expenses due to inflation, it becomes more difficult for the consumer to have any extra money for housing.
“And if they don’t have extra money, it makes it hard for them to trade up — but also the higher rates will lock them into their current loans.”
However, Ulmanis does point out that homeowners have built up a lot of equity over the past few years as house prices continued to rise. Even though prices began to drift downwards in May, the built-up equity should provide a buffer, he adds.
For now, unemployment has remained robustly low in the face of other macroeconomic headwinds. This is likely to be an important data point to monitor in 2023.
“Inflation leads to higher interest rates and that could potentially lead to a slowdown in spending or potential job cuts,” Armstrong says. “That obviously trickles down into consumer balance sheets [too].”
Uptick in private deals
While public issuance slowed in 2022, especially in the second half, issuers began to rely more and more on the private market, bankers and lawyers have told GlobalCapital.
“We have actually seen an uptick in deal activity, definitely in the 4(a)(2) space,” says Trish O’Donnell, partner in Reed Smith’s Financial Industry Group. “More deals are coming every day.”
Section 4(a)(2), also known as the private placement exemption, refers to the Securities Act of 1933, under which the Securities and Exchange Commission (SEC) allows issuers to raise an unlimited amount of capital from sophisticated investors.
Both issuers and investors could continue to find the private markets more suitable in tricky conditions in 2023.
“There is money that needs to be put to work that is long term, so they would rather get a better return than have the liquidity of a public deal,” Robert Villani, a partner at Clifford Chance, tells GlobalCapital.
ESG: in or out?
ESG continues to be a prickly subject for US securitization market participants, and the difficult market conditions are not helping.
Indeed, more than 57% of survey respondents say that the role of ESG in the ABS market is losing its importance because investors have more pressing considerations. Meanwhile, more than 24% say that ESG investors are not resilient enough to be able to move the needle when doing deals is challenging.
“Unless you are the chairman or the CEO, everyone below them says: ‘If it makes my job more difficult, then I don’t care’,” says one investor in New York.
Just 24% of respondents believe that — in challenging markets — it is even more important to be able to attract ESG-focused demand, while only 15% agree that sustainability is proving to be a more important credit consideration. But despite the apparent scepticism of the majority, some issuers do see direct benefits.
“More pools of capital seeking ESG investments mean that these issuances can often price towards the low end of market guidance,” Alexandra Cooley, chief investment officer of Nuveen Green Capital, tells GlobalCapital. “In a volatile market, issuers will be looking to gain an edge, so I believe there will be more momentum in ESG relative to the rest of the market.”
Cooley says that the second half of 2022 had been full of challenges for issuers, with orders from buyers thinning because of a flood of secondary paper.
“However, we continued to see strong investor interest in our C-PACE platform, and we expect a robust year for ESG securitizations in 2023 because there are more and more pockets of capital seeking ESG investments,” she adds.
ESG will continue to be important because investors are under pressure to invest in ESG products and because of state-level government action that is encouraging ESG investment, according to Lau at Lord Capital. However, there are still questions around regulation and understanding of ESG, he says.
There is a similar lack of consensus as to where ESG regulation might go in the US.
About 63% of the survey respondents say that regulation surrounding ESG classification will increase, and about 50% of the respondents think that it is at least somewhat necessary. About 26% of the respondents think that regulations will stay the same, and 10% think that it will decrease considerably. About 35% of the respondents also don’t believe that ESG securitization regulation in the US is necessary.
Villani at Clifford Chance says there is “no reason to believe that there is going to be any regulation on ESG forthcoming.
“I think, depending on what happens in Washington DC, the momentum for that could be decreased.” GC