Yield hunt pushes investors towards esoterics, private ABS
The rapid economic recovery from the pandemic is causing yields to tighten sharply in the securitization market, pushing investors to explore more esoteric ABS sectors and even private credit. Jennifer Kang reports.
The good news is that the US economy is recovering. The Federal Reserve in June said that the economy is running hotter than anticipated and warned of possible interest rates hikes by late 2023. The incredible progress on vaccinations has opened up the economy faster than expected and the Fed has signalled that it is mindful of inflation.
The bad news is it has caused an extreme shortage of yield in the securitization market. The curve steepened noticeably on the front end with the news of three upcoming hikes but, given their shorter duration nature, ABS spreads tightened sharply throughout June.
“To hear that the Fed will raise rates is not a bad thing, because it means the economy is doing well again,” says Richard Talmadge, senior analyst at Insight Investment, a BNY Mellon subsidiary. “But it has caused spread tightening across the sector.”
On-the-run AAA asset classes have reached low single digit spreads, making it challenging for investors to pick up yield just by sticking to plain vanilla sectors. While almost all asset classes are rich, there are still some pockets of value remaining in the less liquid names within esoteric ABS.
“We continue to view ABS fundamentals as favourable; however, a strong technical environment driven by limited supply and an abundance of cash has reduced the attractiveness of on-the-run ABS relative to other securitized products,” says Scott Motta, vice president of securitized products at PGIM Fixed Income. “We remain constructive on higher value ABS, such as select issuers of non-prime auto, unsecured consumer loans and credit risk transfer transactions.”
The Hertz rental car ABS deal showed just how desperate investors have become for yield. The transaction was increased from $2bn to $4bn, with some tranches oversubscribed 20 times, according to Jen Ripper, investment specialist at Penn Mutual Asset Management, a firm based in Pennsylvania.
“The transaction caught me by surprise because of how tight it priced, just given the size and the fact that [the rental car company] is still coming out of bankruptcy,” says Philip Armstrong, senior portfolio manager at Invesco, a global firm headquartered in Georgia. “I was expecting a little more of a spread concession, especially considering the upsize.”
Absent any big problems for the economy, market participants are expected to remain stuck with incremental spread tightening for quite some time, navigating a period of picking up carry as you go, adds Armstrong.
Aside from the usual off-the-run selections such as subprime auto ABS, market participants are paying greater attention to less familiar names in the whole business sector as well.
The most recent whole business issuer that took investors by surprise was Five Guys, the burger chain, which priced a deal just 50bp wider than Wendy’s offering that came one week before.
Wendy’s is an established issuer that has public equity and a $5bn portfolio of whole business securitizations. In comparison, Five Guys is a privately owned entity with about $400m of bonds outstanding, which makes it inherently riskier compared with Wendy’s.
What’s more surprising is that the entire deal was purchased by one investor who came to Five Guys through reverse enquiry because they liked the yield on the paper.
Counterintuitively, another sector that has been gaining popularity is aircraft receivables. Aircraft ABS was the first to see issuance and performance plummet but it has returned with a bang thanks to an explosive recovery in travel demand.
Six aircraft ABS totalling $4bn have been priced so far in 2021, with Sky Leasing’s transaction setting a new record in terms of yield.
Sky Leasing, the third US deal to have been priced since the pandemic began, sold senior notes at a 2.43% coupon, the lowest levels ever seen in an aircraft ABS deal.
Even within the aircraft segment, the lower tranches have been a lot more popular than the senior ones.
“In recent aircraft deals, the triple‑B rated bonds were 10-15 times oversubscribed, but single-A rated subscription levels dropped off meaningfully,” says Armstrong. “From our perspective, where we see value is off-the-run, subordinate sectors like this where you can see favourable fundamentals or improving fundamentals.”
Both whole business and aircraft ABS have had historically wide spreads even compared with fellow esoterics, but they seem to have shrugged off the esoteric title throughout Covid-19 after proving their robustness and liquidity.
“There is a wall of money and capital seems so plentiful,” says Talmadge. “The fact that you are seeing these deals [regularly] means they have graduated from the esoteric title and I don’t see that trend reversing any time soon. It’s hard to put the genie back into the bottle.”
Public to private ABS
Those with flexible mandates, in-house underwriting expertise and a level of comfort with unrated, illiquid deals have increasingly tapped the private market in order to pocket a healthy spread in the 500bp area versus rated public comparables, according to Nelson Chu, founder and chief executive officer of Percent, a private investing platform.
“A private transaction also provides an additional level of comfort to investors as the transaction structures are typically tighter than in the public markets with respect to covenant packages and advance rates,” says Chu.
But while true private deals that are not 144As have also picked up demand, spreads on the private transactions have also tightened, says Paul Norris managing director and head of structured products at Conning, an investor headquartered in Connecticut.
“There’s nowhere to hide,” Norris says. “But given the lack of tiering between issuers, it’s important that you are still picking out the best in class.”
From an allocation standpoint as well, it’s inefficient to go out to the primary market when there is the opportunity to get a bigger piece of the pie by spending a few more weeks working on a bespoke, private ABS.
“We have been very much focused on [private securizations],” says Talmadge. “Everything we would be buying in public, we are pursuing in public. But they are just very tough to come by.”
Even in the private sector, aircraft ABS is a popular choice. There is a “fair amount” of aircraft coming to market on a private basis, Talmadge adds. CMBS is another area where private deals may be more favourable.
While those directly involved in private deals see a slight uptick in activity, the general investor population does not see it as being a major trend, especially as liquidity is still the top concern for most investors.
“If it’s happening, it doesn’t come across the screen,” says Armstrong. “It seems as though investors have resigned themselves to the fact that yield is low on the front end but also recognise that valuations are pretty tight. Liquidity is going to be paramount as we move forward.”
At the inflection point
“It’s worth looking at the resurgence of the mortgage market and the role quantitative easing has likely played in overheating the property market,” says John Carey, managing director in the financial services and technology practice of AArete, a global management consulting firm. “Investors are now stuck between the bond market and private lending, safety and growth. Given the scars remaining from the role ABS played in driving massive market dislocation back in 2007, lenders need to resist short-term opportunities that capitalise on the cash glut in the market.”
The yield shortage is also leading to issuer and capital stack compression as market participants are incentivised to take on disproportionately higher amounts of risk to achieve incremental spread.
“I’d say the market is rational here,” says Greg Handler, head of mortgage and consumer credit at Western Asset Management, a firm headquartered in California. “Some of the names more affected by Covid still trade wider than sectors that were considered winners during the pandemic. Though not as pronounced, tiering exists.”
The big wildcard is when the spreads will become too tight as the market overheats. When that happens, we will see a reversal of the tightening observed in June, sources caution.
“I think we will see a slowdown in the tightening of some flow asset classes,” says Tricia Hazelwood, managing director and head of structured products at MUFG.
“We are at that inflection point, where some accounts may decide to not participate or reduce the size of their orders until they achieve their yield requirements.” GC