The market for non-traditional asset-backed securities has grown to nearly a trillion US dollars today. We speak with Brown Brothers Harriman’s Neil Hohmann about the unique characteristics of these securities and their role in an institutional portfolio
When discussing financial innovators, it is not often that the name of David Bowie comes up. Yet, in 1997 the artist and his banker David Pullman came up with an ingenious scheme to buy back the rights to the part of David Bowie’s music that was owned by his former manager, Tony Devries.
Pullman created a bond that provided investors with a fixed annual return of 7.9 per cent over a period of 10 years. This income was backed by the royalties that Bowie was entitled to from 25 albums he previously made.
Partnering with Prudential Insurance Company, Bowie raised $55 million and managed to buy back the rights to all of his music.
It was the first time the intellectual property of an artist was used to create an asset-backed security (ABS). Apart from mortgage-backed securities, most traditional ABSs at the time consisted of bonds backed by credit card receivables, auto loans, or student debt.
But since then, the segment of non-traditional ABS has grown to about 70% of the $800 billion US ABS market and includes more than 30 categories, ranging from bonds backed by aircraft leases to telecommunication towers and even data centres.
For institutional investors, these bonds offer a rich source of diversification, while offering relatively high yields and better liquidity than private debt.
Bonds backed by assets such as telecommunication towers and data centres typically provide 7 – 8 per cent yields, while asset types such as triple net leases or recurring revenue loan ABS can deliver 8 – 9 per cent a year. More risky asset type ABS, including venture debt can yield even more than 9 per cent.
The very large, trillion dollar money managers can't invest in a US$200 - 500 million tranche. So we do not see these referenced money managers investing in this asset class. It's a set of insurers and medium-sized money managers
“The reason that those yields and spreads are so high is because there’s a relatively small set of investment managers in this segment,” Neil Hohmann, Head of Structured Products and a portfolio manager with US private investment bank Brown Brothers Harriman says.
“The very large, trillion dollar money managers can’t invest in a US$200 – 500 million tranche. So we do not see these referenced money managers investing in this asset class. It’s a set of insurers and medium-sized money managers,” he says.
A key reason for the ample liquidity is that the bonds are generally short-dated and there are plenty of investors, especially insurance companies, who are interested in non-traditional ABS, while there are few issuers.
“They’re relatively short-dated bonds, mostly two to three year bonds. So there’s a lot of issuance, close to US$ 300 billion of issuance a year,” Hohmann says. “However, it is hard to buy ABS in secondary.
“The liquidity is good on the bid side. For example, when occasionally requested, we have little difficulty disposing of large portfolios of 50 or 60 bonds in a matter of days and typically near our marks,” he says.
Although many non-traditional ABS are similar in structure, they are based on an eclectic mix of assets and as such are hard to benchmark. Investors often use indices, including the Bloomberg US ABS Index, or the J.P. Morgan Other ABS Index as reference points, but a typical portfolio of non-traditional ABS tends to not track these indices very closely.
This does mean this segment comes with low absolute return volatility but possibly a relatively higher tracking error.
“Highly benchmark aware managers or passive strategies aren’t going to own them,” Hohmann says. “In the US, it is mostly insurance companies that are taking advantage of this market.”
Surviving Crises
Although the yields of non-traditional ABS are relatively high, the asset backing and the fact that the bonds are not stretched to the full value of the underlying loans mean the bonds are not as risky as their return profile might suggest.
The majority of these non-traditional ABS, therefore, tend to attract investment grade ratings.
“What allows these structures to mainly carry an investment grade rating is the credit enhancement beneath them,” Hohmann says. “For example, if you had a US$ 1 billion pool of dealer floor plan loans, then in a typical deal the total debt issued secured by US$ 1 billion of loans often might be only US$ 850 million.
“You have an US$ 150 million, or in this case 15 per cent, credit enhancement. This credit enhancement is a safety cushion that provides great protection against the loans in the pool defaulting without any recovery rate.
“These ABS deals are credit enhanced to a level where the rating agencies feel very comfortable providing a triple A rating, which is rare in the bond universe today. They’re also in bankruptcy remote trust structures, which provide protection for investors against the bankruptcy of the associated originator,” he says.
These ABS deals are credit enhanced to a level where the rating agencies feel very comfortable providing a triple A rating, which is rare in the bond universe today. They're also in bankruptcy remote trust structures, which provide protection for investors against the bankruptcy of the associated originator
This structure limits the losses in periods of crisis. For example, Brown Brothers Harriman estimates that during the global financial crisis of 2007 – 08 the cumulative loss rate on ABS was only three basis points.
“That’s very different from non-agency RMBS, where the average losses were multiple per cent or even different from corporate bonds, where the cumulative default rate could range well over one per cent,” he says.
The start of the global coronavirus pandemic provided another stress test for the sector. Especially non-traditional ABS on aircraft leases proved to be heavily impacted and although Hohmann held little aviation-linked ABS in his portfolio, he says even in the midst of the turmoil these bonds managed to avoid default.
“We have a new stress test for aviation ABS now and it’s called ‘2020’. Lease payments from airlines ceased for the most part during that period. It’s about the most severe stress you can imagine,” he says.
“There was a lot of renegotiation, and so aviation was one of the asset classes that experienced significant downgrades, moving from investment grade to below investment grade.
“But it is also an asset class that has durable assets underlying it. And we’ve since seen a complete recovery in travel,” he says.
The quality of the underlying assets and the credit enhancement structures of these ABS meant that the bonds held up as airlines recovered. Today, many airlines are in good shape again, although this hasn’t been reflected in their ABS ratings yet.
“We avoided aviation ABS for the most part, but it also shows that it’s very important to understand the risk factors that different segments are exposed to,” he says.
But apart from the troubles in the aviation industry, the overall non-traditional ABS sector held up pretty well during 2020. A Brown Brothers Harriman study showed that only four out of the roughly 30 different types of ABS experienced downgrades to below investment grade.
“That is a pretty remarkable durability, when you think about it relative to the corporate market, where perhaps a third of corporate names were downgraded” Hohmann says.
This article is sponsored by Brown Brothers Harriman. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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