Global ABS 2024: KBRA's Day 2 Recap

KBRA reviews day two of Global ABS, showcasing investor, issuer, researcher, and CLO investor viewpoints and many other topics

Day two of the Global ABS 2024 conference covered a packed array of topics, including everything from geopolitics to environmental, social, and governance (ESG) factors on top of the usual securitisation sector coverage. The conference’s second day is typically very busy, and this year was no exception, with business meetings and insightful conference panels and presentations — including innovative financial technology businesses from the new Innovation Zone. Proceedings began with several networking breakfast meetings, followed by a keynote speech from Ludovic Subran, chief economist of Allianz SE, and concluded with the Researchers’ Roundtable. The wide range of panel discussions included subjects like trade receivables, residential mortgage-backed securities (RMBS), Basel regulations, and more.

Below we provide a recap of some of the day’s panel topics:

Plenary: Investor Roundtable

This plenary panel was, as usual, well attended, focusing on investor views of the market. Currently the view is that while there is a great deal of positive direction in the market, there are some concerns going forwards. Investors said that where they are seeing value is in collateralised loan obligations (CLO) at the senior side and would own it for high-quality carry strategies. Prime RMBS is seen to be at a good level, with good value relative to other sectors. Non-prime RMBS are migrating to levels seen as relatively tight. An audience poll highlighted that CLOs offer the greatest value, with the next most popular being prime RMBS.

European securitisation has performed well despite initial expectations of challenges from rising interest rates. Speakers discussed the importance of hedging and geopolitical impacts, as well as basis risk and increasing defaults in the small and midsized enterprise (SME) and corporate space. Autos continue to demonstrate strong performance with low arrears. Increased rates have affected non-prime but excess spread was able to absorb the liquidity stress. The shift from short-term interest rate shocks to longer-term interest rate expectations is also a concern, as a higher-for-longer rate environment risks impacting performance. Overall, the market’s resilience and potential for growth were noted, but caution was also expressed due to these ongoing challenges.

Panellists also discussed issues around the lack of hedging in deals, and differences between private and public sides of the market were highlighted. One panellist raised their frustration with this hedging matter, noting the risk of downgrades and basis risk, as interest rates can be inefficiently swapped in some transactions. Investors prefer to have strong swaps in place to separate the interest rate risk from the credit risk of the collateral.

ESG considerations are growing in the financial industry, and one speaker predicts a transformed public market in five to 10 years given ESG, green energy, and private credit influences. They expect to see greater data availability in transaction reporting, which should support their ability to make ESG investments and help to assess correlations.

Spotlight: Trade Receivables Are Riding High, but Why?

The speakers in this spotlight session noted that the emergence of US issuance has attracted a new investor base, resulting in a competitive investment environment and compression of spreads. On the legal side, speakers discussed how investors are analysing deals on tight time frames, highlighting important documentation terms to focus on, albeit bearing in mind that these deals are still private and not standardised.

Key considerations discussed included what counterparty the investor is facing, banks versus special-purpose vehicles (SPV), what form of risk transfer instrument is being used, the location of the investor (which has implications for securitisation regulation application and compliance), optional termination events, security, voting and control rights, information rights, and the scope of the restructuring credit event. The speakers remarked that significant risk transfer (SRT) deals suffer from a general asymmetry of information, and there are often negotiations around the time frame for notification of credit events, the appointment of verification agents, and the scope of their appointment.

The speakers examined disclosed versus nondisclosed pools, noting that it can be difficult for investors to underwrite disclosed pools of midsized corporate loans where there is limited information. In those circumstances, some investors may have a preference for nondisclosed pools and a reliance on the banks’ ratings. One speaker commented that if you are investing in nondisclosed pools, you need comfort regarding the counterparty bank’s strategy, including that the bank is in that business line for a good reason, intends to remain in that business line, and is a market leader, and that there is not significant competition. In essence, an investor needs to be convinced of the bank’s quality and strategy.

The speakers also discussed how the emergence of US banks has brought new legal risks to the transactions, including which party (bank or investor) should bear the risk. In addition, there are issues around the preferred risk transfer instrument and whether the structure of the transaction can create risks around tax issues relating to whether a party has a US trade or business. Insurance indemnification solutions can be one mitigant.

Finally, the session covered the performance of SRT transactions in the case of an insolvency of the counterparty bank. The speakers noted that, generally, the understanding is that an SRT transaction should be allowed to run its course in the case of a bank insolvency and should not be impacted by bail-in under the bank recovery and resolution directive. However, the regulation could be clearer on its application to SRT transactions. In any event, the risk needs to be understood and underwritten in all applicable jurisdictions.

Plenary: Issuer’s Roundtable

After the investor discussions, issuers offered their focused perspective on the market. Issuance in Europe is the highest since the global financial crisis, according to the panel. Deals are being oversubscribed and the market is positive from an issuer perspective. However, panellists pointed to certain structural constraints that limit the amount of European issuance, such as a detachment between senior and mezzanine interest in Europe and lack of a sufficient domestic European market for senior tranches. One issuer said they saw 10 times oversubscription for the mezzanine and junior tranches on one deal, whereas much of the senior tranches needed to be preplaced. They felt this was a common theme for deals sized over €600m in Europe. This is driven by the punitive regulatory treatment of European asset-backed securities (ABS) to those potential senior purchasers.

Panellists commented that when issuers are pursuing a transaction, there are various considerations before proceeding. Banks look at transactions that will help their capital optimisation. This comes down to maximising the regulatory considerations, which leads to specific capital relief trades, such as the growing SRT transactions. For nonbanks, it is about funding and liquidity. For most issuers, it is also about the readiness of certain jurisdictions to having a public transaction, and many will start with a private transaction first. It was noted that investors like to see regular issuance, so for many issuers, this is a consideration when bringing a transaction.

The panel discussion also covered sustainability and the issuance of green securitisations. Here the issuer needs to consider if they can raise sufficient green collateral or whether the proceeds have green goals. One panellist said that in Australia green collateral issuance has been increasing, with approximately 15 transactions with green tranches, and to date there has not really been a green premium. Another conveyed that it is not just green securitisations finding appeal, but also social, with some transactions being considered for providing lending to underserved borrowers.

Lastly, the issuer outlook for the second half of 2024 is optimistic, but the panel is worried about a few issues — such as geopolitics, elections, and the direction of rates. One panellist expressed cautious optimism about spread tightening but was sure it could last to year-end. Another said that they were always optimistic.

CLO Investor Perspectives

The panel’s CLO investors suggested the market may be nearing a peak. At the moment, there is a lot of money, but not a lot of assets, creating a positive pricing environment. Panellists felt that senior tranches could price tighter even though they are already relatively tight. There is a large amount of amortisation that is expected to continue. If these funds are recycled back into the market, this should support tightening and further issuance. So far this year, many managers have returned to resets and refinancings given current spread levels. As a result, the panel conveyed that 2024 could be another record year, similar to 2021, if things continue at their pace to date.

The panel expects defaults to reach 3%-4% at the end of the year, with most fundamentals relatively strong. Broadly, there was not much concern that there is a potential wave of defaults on the horizon. There was some debate about whether inflation has been curtailed and whether rates can come down.

The panel noted that one of the drivers of the market issuance is an increasing number of captive equity funds. One panellist suggested that the market is split in the middle between captive and third-party equity-sponsored transactions. The only way to get double-digit yields is to go into equity, but if there is limited third-party equity available, these yields could still compress. Captive equity will likely be a permanent feature of the market, and it makes the market more dynamic, given funding is already available to do a transaction. In comparison, third-party equity offers greater flexibility, according to the panel.

Private credit CLOs are trying to penetrate the market in Europe as they have in the US. However, the lack of depth on the collateral side presents challenges to getting a transaction completed. One panellist suggested that there might be some structural innovation to make it work for lower quality assets. Overall, in the short term, the panellists remain positive on the prospect for the market to develop.

Global RMBS Perspectives

An RMBS panel cannot avoid discussion about the UK market, as it represents approximately two-thirds of the European securitisation market, according to the panel. It is a product that will always compete with covered bonds to some extent, but there is a different investor base for the two products. Also, they are different issuers, as most of the securitisation market issuance is dominated by nonbank lenders, and the covered bond market by banks.

The panel discussion crossed borders, with comments covering UK, Dutch, US, and Australian deals, among others. In the Netherlands, the market is dominated by prime mortgages given the code of conduct. It has historically been a high loan-to-value and interest-only market due to the tax advantages. Across Europe, the market is largely dominated by floating rate products in southern Europe, while northern Europe has a tendency to contain longer-dated fixed rate mortgages. Uniquely, Ireland used to be a floating rate market but has since migrated to a similar structure to the UK, with two-, three-, and five-year fixed rates.

In Australia, the market is mostly floating rate, with banks dominating the prime securitisation market and nonbank lenders focusing on nonconforming mortgages. The US presents a different picture, with 30-year fixed rate mortgages and no prepayment penalties.

The panel does not expect the market to change dramatically in the year ahead, with the UK remaining Europe’s dominant region of issuance. One panellist noted that there is a rise in second lien and home equity line of credit issuance as borrowers look to take advantage of increased equity in the home. Another panelist noted the increased interest for European risk retention investors in the US given the large amount of supply.

Evolution of Specialty Finance

Specialty finance, which is essentially the nonbank provision of financing, is increasingly coming into the mainstream, according to the panel. The UK market took off in the mid-2010s with buy-to-let and other specialty mortgage loans. Over the past several years, this has expanded to include financing for consumer loans, credit cards, data centres, fibre, music royalties, and solar panels. There were also plenty of more products across Europe, including buy now, pay later products to help finance the energy transition, such as electric vehicles and heat pumps. Further, there has been growth in home loan products such as second lien and later-life lending.

These nonbank lenders are increasingly using specialty finance instead of venture capital, if possible, as it is more expensive. The investors and lenders are largely driven by the yield on assets rather than funding costs. Specialty finance’s area of differentiation is on the speed of execution, ability to asses the niche markets, and differentiated servicing to the retail banks. With capital rules evolving, banks go in and out of different asset classes as best suits them.

In terms of securitisiatons, the protections in place have become more standardised as more issuers come to the market. These include the use of parent guarantees, financing covenants on the operating company such as net worth or liquidity, and key man clauses. These are important to help improve investor comfort with the transactions.

Over the next 12 months, the market is expected to continue growing and diversifying across geographies and product types. There is hope among panellists that there will be a greater use of financing to drive and support the energy transition in Europe. They expect the use of securitisation will help support continued growth of the market. However, regulations can prove to be difficult for small businesses, slowing the progress of potential execution.

Researchers’ Roundtable

The annual researchers’ roundtable featured KBRA’s Gordon Kerr in a discussion about the state of the securitisation market. Panellists felt that the current state of the market could be characterised as “basking in the sun” given the positivity coming into the conference. Spreads have been tightening, issuance has increased, and while there was some hesitation about whether this could be sustained, there was little to suggest that it could not. The panel had been surprised by the strength of the issuance so far this year. The consensus was that growth in issuance was expected, but the scale of that growth had beaten expectations. So far in 2024, it is the first year of positive net supply in many years, with a good balance of banks and nonbank issuers, as well as new entrants.

It was noted that there appears to be a growing dislocation between asset performance and spreads. Asset deterioration in the UK is focused on nonconforming mortgages, largely from pre-crisis origination. In the prime market, mortgage arrears have remained stable. In the auto sector, performance deterioration has been minimal, as it has also been in consumer credit so far. However, there was some disagreement on whether there is the potential for further collateral performance deterioration, with the sense that the market may have further to go.

Discussion also turned to the private credit markets and how they should be defined, with growth in this space expected to continue, particularly in SRT. One panellist suggested this market could still grow by 20% in the year ahead, even if yields are continuing to compress. Overall, the panel felt that in the public securitisation markets, this could suggest a differentiated picture between supply momentum and spread performance. Overall supply is expected to continue in the second half of the year, although many panel members were not 100% convinced this will be the case.