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Latest Federal Reserve inflation policy update kicks off a new flight to yield in ABS market

By Jennifer Kang
15 Sep 2020

ABS investors are wading deeper into the market for esoteric assets, prompted by the Federal Reserve’s updated view on inflation that is sure to keep rates lower for longer and further compress yields across fixed income.

On August 27, the Federal Reserve announced that it will allow inflation to run higher than its long-standing 2% target, which signalled that interest rates are likely to remain at or near zero through 2022. The historic announcement, delivered by chairman Jerome Powell at the annual Jackson Hole symposium, kicked off a frenzied search for yield among investors across the capital markets.

In recent weeks, deals that have come to market have been at least five times oversubscribed, and it has not been unusual to see deals up to 10 times oversubscribed, said an ABS syndicate banker. 

“We did a transaction recently and I was taken aback just by the sheer breadth of investors involved,” the banker said. “For a dozen investors, it was their first foray into this particular asset. Investors are expanding out the assets they participate in because there’s just so much money that needs to be put to work.” 

Newcomers to securitization, ranging from large insurance companies to endowment funds, are finding structured products more attractive versus corporate bonds because even though demand for securitizations has been high, the market has generally lagged behind the rally that has swept through the investment grade market. 

The wide-ranging hunt for yield has been a long-running theme since the recovery from the 2008 financial crisis and investors have navigated low rates for years, hoping to be paid extra for doing the additional work needed to understand esoteric assets. 

Investors backed out of the esoteric market briefly in the spring, when Covid-19 struck, seeking shelter in “middle of the fairway” assets, but quickly returned when the government showered the market with various stimulus programmes, according to Tom Rutledge, fixed income strategist at Magnetar Capital. 

“This kind of low interest rate environment has been generally bullish for fixed income investors and esoteric ABS,” said Rutledge. “Investors aren’t rushing right away into asset classes they haven’t previously explored, but over time, given the search for yield, you will see a growing acceptance of more exotic asset classes.” 

Commercial ABS regains momentum 

Commercial asset classes in particular have gained popularity, as many investors nervously anticipate an extended downturn for US consumers. 

However, picking up yield has also meant investors are venturing further down the credit spectrum and into off the run consumer assets such as unsecured consumer or subprime credit card ABS. Meanwhile, commercial sectors considered esoteric but high quality, such as cell tower and data centres, no longer generate attractive yields because spreads have come in so tight. 

Demand for esoteric paper is evident in the slew of deals marketed since the Fed announcement, which includes an assortment of container, timeshare, small or medium ticket equipment and data centre ABS transactions.

Shipping container ABS has become especially popular because of its longer average life, at five years, which allows investors to extend further out the yield curve, according to Wells Fargo analysts in a consumer ABS market update.

In August and September alone, the container sector saw eight deals priced, bringing year-to-date volume to $5.52bn, the highest amount recorded since 2000.

“Commercial ABS, such as container ABS, offer investors a chance to diversify risks away from the US consumer and still pick up spread and yield,” wrote analysts in a report in early September. “Commercial ABS can also allow investors an opportunity to extend out the yield curve within ABS and take advantage of the steepening that has occurred.” 

Investors’ desire to reach further out the yield curve has also been observed in whole-business securitizations, where bankers and investors are talking about crafting 12-15 year deals for the highest quality issuer names, sources said. 

Timeshare, though consumer facing, is another area where investors are showing greater interest after the Fed’s announcement, owing to the “rock solid” structures and heavy credit enhancement.

“[The Fed’s announcement] could mean some of the asset classes in the esoteric world — timeshare, for example — will look attractive as investors search for yield,” said Bob Gahagan, senior vice-president and senior portfolio manager at American Century Investments. “You might think that’s one area you want to avoid, given the outlook for employment, but those are pretty rock-solid structures, particularly given the high FICO scores, the strong credit enhancements, and if you stick to strong issuers like Marriott and Hilton.”

Taking advantage of favourable market conditions, Holiday Inn Club Vacations, previously Orange Lake Country Club, issued a deal under the Holiday Inn name for the first time in September. This was also the first deal to include a class ‘E’ junior tranche rated below BB, which priced with a yield of 8.55%.

“If you had asked the average securitization investor in March when timeshare is coming back, they would have maybe said never,” Christopher Brown, portfolio manager in T Rowe Price’s fixed income division, told GlobalCapital. “And that new issue market re-emerged in July and went extremely well. Deals were heavily oversubscribed in levels I have rarely seen, 10 to 15 times.” 

A new paradigm for inflation 

However, by allowing rates to stay low for years to come and letting inflation run higher, the Fed runs the risk of laying the groundwork for a bear market, sources cautioned. 

“Market participants are definitely viewing the Fed’s new approach as bearish for the long end and potentially inflationary. We would agree,” said Sam Dunlap, chief investment officer of public strategies for Angel Oak Capital Advisors. “Letting inflation run hotter and employment higher for a long period of time should be bearish for long-term fixed income.” 

Dunlap added that investors should not fight the Fed and “its commitment to higher inflation,” especially at the long end of the curve. 

As the Fed continues quantitative easing, it also increases the chance of “more cyclical volatility in asset prices” — in other words, asset bubbles, according to Fed governor Lael Brainard. The prolonged expectation for lower rates and increased risk appetite may give way to a heated stock market and put the US dollar at further risk, Brainard said in a speech delivered at the Brookings Institute, Washington DC, on September 1.

“It feels like we are already seeing asset bubbles,” one esoteric ABS banker noted. “There is just so much money in the system and not enough opportunities. We are already in the bubble, at least on the equity market side.” 

That said, there are few near-term risks to stop fixed income investors from crowding the esoteric ABS market, as all-in borrowing costs hover at historic lows. 

“I think it’s a problem for tomorrow. You have to ride this wave right now,” said Brown. “It’s something that will have to be addressed down the road and there’s a lot to be seen in the months to come. The Fed wants to change the paradigm on inflation, but the desire and the ability to do so are two different things.”  GC

By Jennifer Kang
15 Sep 2020