In the land of volatility, securitization is king

The last couple of years have proven, not that it could have been in any doubt, that capital markets are by no means safe from geopolitical ructions. The securitization market's resilience may offer a haven from the resulting volatility to investors.

While many investors left the asset class after regulatory changes following the 2008 global financial crisis reduced the relative value of the product, European ABS has proven to be both a strong performing and liquid product since then.

Wider equity and bond markets have been volatile since the Iran war started in February, which only added to geopolitical uncertainty from longer running conflicts like the Ukraine war.

It is unlikely this uncertainty is going to be resolved anytime soon, especially when considering also US president Donald Trump's willingness to unsettled markets across a range of policies.

Certain countries like France, with its fractious budget debates and spiralling deficit, are finding that it's domestic political instability is contributing to bond market pressure.

There are more budget negotiations imminent and then what is likely to be a hotly contested presidential election next year. Another sovereign credit downgrade is a risk.

While Moody’s, S&P and Fitch allow corporate issuer ratings to exceed their respective country’s rating, a sovereign downgrade is likely to pose a higher risk to a corporate bonds than an asset-backed securitization as the cash flows are directly tied to the issuer in the former, but only tied to a bankruptcy-remote pool of assets in the latter.

Investors clearly have concerns around the relative value of French government bonds as the spread for 10 year OATs over Bunds went over 100bp recently, the highest level since 2012.

This is in stark contrast to the French ABS market where issuers are piling in with debut deals from BoursoBank, Rothesay and Cofidis this year, while other issuers have achieved tight spreads.

French bank and bank subsidiary issuers like BoursoBank and Cofidis can get cheap funding through the deposits they hold or through their owners, but these issuers see the value in having a diverse funding mix, which will only become more valuable as markets grow more volatile.

While it may have been reasonable for ABS investors to say last year that the French market was not large enough to justify their takeling the time to do the credit work on these products, it is hard to make that excuse now as issuance increases.

Investors not active in the ABS market also should not delay their entry, as the complexity of the product and due diligence requirements mean it is difficult to make a quick switch tothe asset class if the relative value of other bonds declines.

ABS is not completely dislocated from sovereign risk, with the Italian market providing evidence of this. Fitch and Moody’s cap their ratings so senior Italian ABS tranches cannot be rated more than six notches above the sovereign.

There is no consensus among ratings agencies around how exposed ABS is to sovereign risk, as agencies like DBRS and Scope do not impose a sovereign cap.

S&P also updated its methodology in April to allow an eight notch cap instead of six for Italian ABS under certain circumstances, like if the transaction has a short weighted average life and low sensitivity to a sovereign default.

There are no Italian corporate issuers with a triple-A rating from the three main ratings agencies, while it is common for senior Italian ABS tranches to achieve the maximum rating.

A big part of the appeal of ABS is that deals have several structural protections like cash reserves and excess spread to make sure bond payments continue to be made during difficult times.

Corporate and sovereign bond investors on the other hand may face sleepless nights around how potential sovereign credit rating downgrades, and credit conditions generally, will affect the quality of the bonds they hold while markets are turbulent.

This gives senior ABS a big edge in these volatile times, as bank treasuries can use these high yielding products in their mix of High Quality Liquid Assets (HQLA) if they are Liquidity Coverage Ratio (LCR) eligible.

The other reason that investors should start looking at ABS is because these products are typically floating rate bonds and are therefore protected from rising rates.

The days of the ultra-low interest rates between the 2008 financial crisis and the Covid-19 pandemic are long over, and signs suggest that the inflationary pressures in the UK economy for example could lead to one or two 25bp base rate increases from the Bank of England over the next few Monetary Policy Committee meetings.

Securization may prove too complex an asset for some portfolios and too illiquid, or even too small, for others. But those with the ability to buy it will find a high spread haven compared to much of the bond market.