Esoteric ABS boom fuelled by move beyond fast food
Esoteric ABS is not quite so esoteric in the era of low interest rates. With anaemic yields and low economic growth expected to continue, more investors have turned to the asset class over the past few years, and issuers are locking in the lower cost of capital while it lasts
While plain vanilla asset classes, such as auto and credit card ABS, still make up a larger portion of the US securitization market, esoteric asset classes have grown in number and variety, exceeding $61bn in issuance in 2019.
Many once-niche asset classes are hitting the market more regularly. In 2019, aircraft leasing, whole business, marketplace lending and small business loans all saw more issuance in terms of both deal count and size.
Low interest rates have pushed issuance volumes up, says Philip Armstrong, senior portfolio manager at Invesco’s structured investments team in Atlanta.
“There was a desire for issuers to come to market or refinance this year, just to lock in that lower cost of capital,” he says. “That definitely drove some degree of issuance. It was also a function of firms or issuers looking to grow their business.”
A number of the ABS sub asset classes did not even exist 10 years ago and the use of big data analytics was not part of the process, says Manish Kapoor, managing principal at West Wheelock Capital.
Because of the structural protection offered by securitization, ABS allows issuers to bring in a new asset type and obtain an investment grade rating where they would otherwise be rated junk in the corporate debt market.
“Imagine you’re an unsecured debt research analyst. If you went to sleep for 100 years and woke up today, some mechanisms may have changed but the fundamentals of how things get done would be similar,” says Kapoor. “But if you were an ABS research analyst and you went to sleep for just 10 years, you would not recognize the market, the tools or the way analysis is done nowadays. The sheer amount of innovation in ABS is stunning.”
The possibility of such innovation, in the ways that deals are structured and engineered, has allowed new asset classes to emerge, and as the asset classes diversified, a growing number of new investors entered the space. Compared to 10 years ago, large endowment or pension fund investors who were once absent from the securitization market are dedicating a “fairly decent chunk” of their books to ABS as they look for yield and to diversify their fixed income books, says Kapoor.
“In the ‘other’ category, we’ve definitely been competing for that risk against a much bigger universe of investors than in 2016 or 2017,” says Dave Goodson, head of securitized and portfolio manager at Voya Investment Management. “We’ve seen this trend in the making for last couple of years. The buyer base has been snatching up this risk. What I’m looking at next is, will there be more new technology that will enable other asset classes to be securitized?”
Burgers, babies and bonds
Whole business and franchise ABS was a sector that boomed in 2019, and promises further growth in 2020 following the successful debuts of several second and third tier franchisors, say market participants.
From the buyside, investor sophistication and comfort with whole business assets is set to increase, says Tom Rutledge, head of fixed income originations at alternative asset manager Magnetar Capital in Boston.
“Alternative asset investors are often the first movers when it comes to esoterics,” he says. “The investors and firms that don’t have strict limitations of credit ratings will often jump in first and get paid in return for being flexible and doing the underwriting work. That lifecycle trajectory you see now in esoterics will continue.”
The growing speed with which investors are understanding new structures is evident in the wide range of whole business transactions seen in 2019. Along with the typical fast food chain offerings, the market also saw a pre-school education franchise deal from Primrose Schools and a music licensing agreement deal from SESAC.
“The big difference in 2019 was the mix of what’s been issued,” says Armstrong at Invesco. “Going forward, that mix of issuance will become more diverse as ABS provides a low grade issuer with an opportunity to achieve an investment grade rating.” Compared to unsecured corporate debt, the cost of funding is notably lower in the whole business securitization market, Armstrong adds.
Aircraft ABS flying high
Aircraft ABS flew beyond its 2018 record to reach $8.79bn in 2019, driven by a similarly expanding investor base. Aircraft ABS transactions were more popular and moved faster than any other transportation ABS sub asset classes when it entered the primary pipeline, says Caroline Chen, senior vice president at Income Research + Management in New York.
“It was amazing to see the aircraft deals move much faster than other transportation asset classes, like railcar,” she says. Investors seem to like the yieldier nature of aircraft ABS and appreciate the deeper liquidity that exists in that sector, as opposed to other commercial ABS paper.
More banks are arranging deals, alongside the proliferation of first-time issuers and interested investors. Deutsche Bank was dominant in the sector in previous years, but other names such as Goldman Sachs and Natixis are dedicating more resources to aviation, says John Kerschner, head of US securitized products at Janus Henderson in Boulder, Colorado.
“We have been attracted back to the ABS market by the new technology of the transaction structure, especially the tradeable ‘E’ notes,” says Timothy Ross, head of investor relations at Singapore-based lessor BOC Aviation. “We expect to see more investors attracted to aircraft ABS in the future.”
Drilling for yield
Despite an increased focus on ESG strategies, oil and gas royalties emerged as an attractive securitized asset class at the end of 2019, and a wave of deals is expected to hit in 2020, as more traditional sources of funding, such as reserve-based lending, becomes more expensive for oil and gas producers.
Historically, oil and gas companies have always been big consumers of capital, but given where oil prices are — WTI has hovered between $55 and $60 for much of the year — and leverage in the industry, it has been tough for these companies to raise equity or unsecured debt. There are consistent market participants in the bank space active in reserve-based lending, but that volume is not growing.
It’s an interesting time for such a product to hit this market, says Goodson, since a lot of people are making the argument that oil production is becoming less valuable. Some investors say they won’t be interested in oil and gas royalties even if it hits the mainstream market because there are a lot of idiosyncratic risks involved.
“My guess is that oil and gas companies saw the success that whole business ABS has had with getting low cost of financing,” says Goodson. “The oil and gas companies may be seeing the high yield bank loan market becoming choppier.”
High return, high risk
However, reaching too far for yield may come with consequences.
“If you’re reaching too much for a new realm of collateral, there’s always a chance you could miss something when doing the underwriting — and underwriting is even trickier with esoterics,” says Rutledge. “That potential is something that could slow the growth of esoteric ABS.”
Even the most popular forms of whole business ABS — fast food franchise concepts — are at risk, especially because of their ties to the corporate unit. For example, Applebee’s has a very different business strategy to Domino’s Pizza, even if at first glance they both appear to be similar companies in the same sector.
“On the surface, you may think all fast food franchises are more immune from the recession, but if you look closely, each individual company is different,” says Tracy Chen, portfolio manager at Brandywine Global. “You have to do your due diligence — get all the related documents, read it and do the work to make sure the company is steady and strong.”
With global liquidity drying up, it “doesn’t make a lot of sense” to be investing heavily in esoteric ABS, says Brandywine’s Chen. Whole business ABS bonds have been enjoying decent liquidity over the last few years, but the current situation is not ideal because of slowing growth and fierce competition among fast food brands.
Although aircraft ABS has been highly popular, there is a substantial group of investors who question the structural integrity and fundamentals of the sector.
“So much money has been pushed into non-benchmark types of risk, like aircraft ABS, because of the yield offering,” says Goodson. “I don’t think it’s because people have a particularly bullish view on the industry — because it’s been train wreck after cyclical train wreck. It’s more of a function of an incredibly generous monetary policy.”
Those who do participate in aviation ABS are very selective in the investment process. For example, Barings makes sure that it invests in transactions with strong servicers that have a long track record, says Doug Trevallion, head of global securitized and liquid products at the investor. Trevallion does not participate in inaugural deals or off-the-run aircraft types, paying special attention to the equity alignment and skin in the game for the different parties of the transaction. GC