David Favier, senior portfolio manager of European ABS strategies, reflects on the impact of the pandemic and the outlook for 2022.
Covid-19 created great uncertainties in the market. How did European asset-backed securities do during this period?
The short answer is that they held up well. Admittedly, ABS markets were hurt in the initial stages of the outbreak and during the ensuing lockdowns – specifically in February and March 2020, when uncertainty and market volatility peaked.
During this period, spreads widened by a multiple of two to three across most major countries and sectors irrespective of the issuer’s credit rating. There were similar, indiscriminate moves all across the credit asset class: most major credit markets saw similar levels of spread widening (see Exhibit 1). It was not just ABS.
Exhibit 1: European credit spreads have narrowed again after a pandemic peak
Source JPMorgan, Bloomberg, BNP Paribas Asset Management, as at 28 January 2022
The market rebounded quickly with spreads narrowing to almost pre-pandemic levels by the end of 2020. As an example, all three of our ABS strategies had completely recovered by December.
Encouragingly, liquidity and credit performance were resilient. Even at the height of the volatility, the secondary market was active with bid-ask spreads remaining stable. There were no material credit events in the European ABS market. In fact, there were credit rating upgrades. All of this highlights the quality of this market.
Should investors worry about rising inflation and the likelihood of rising policy rates?
Unfortunately for investors in traditional and core fixed income, rising inflation and higher interest rates can pose significant headwinds. Particularly in Europe, we have seen notable increases in inflation over the past year. For example, inflation rates have more than doubled in the UK to close to 5.4%. The pressure is even higher in Europe, with inflation rising from close to 0% to about 5%.
Given these levels of inflation, the market is expecting four to five rate rises from the ECB and more from the US Federal Reserve over the next 12 to 24 months. This will hurt government and corporate bonds and fixed income instruments generally. Low yields are exacerbating the problem for investment-grade credit: its tiny income cannot offset the adverse impact on performance of falling bond prices.
Do you see any other major challenges this year?
A substantial headwind for most major credit markets is the expected tapering of asset purchases by leading central banks. After the pandemic broke out, the ECB drastically expanded its quantitative easing (QE) in the form of asset purchase programmes to support credit markets and the broader economy. Its pandemic purchasing programme amounted to a massive EUR 1.5 trillion.
This sizeable support enabled bonds to rally over the latter half of 2020. However, all this liquidity and the market’s reliance on the ECB could now become a headache. The ECB intends to scale down QE, with tapering possibly starting this year. Credit markets that have relied on these large programmes will likely face challenges. This is not the case for ABS (see Exhibit 2).
Exhibit 2: Asset-backed securities barely featured in ECB QE programmes
Source: ECB, Dec 2021
How do you expect European ABS to perform in 2022?
The segment is well positioned given its characteristics: ABS bonds have floating rates; they also offer a yield premium. As floaters, the duration of ABS is close to zero, meaning the anticipated rate hikes should pose fewer challenges. That is not the case for corporate credit and government bonds.
Unlike other corporate bond markets, European ABS did not rely on ECB support. European ABS purchases comprised of less than 1% of total QE, and the asset class was not even included in the ECB’s pandemic purchasing programme. Any tapering should have little effect on the market.
We believe that any additional supply of senior paper (i.e. the higher-quality STS segment of ABS) will be largely absorbed by banks looking for high-quality, liquid investments as part of their Liquidity Coverage Ratio (LCR) programmes. [1]
For the ABS and CLO markets, I’d like to note that these securities involve pools of loans granted to households. Current pools (i.e., the collateral of ABS) have passed the “Covid-19 test”. Most came out of payment holidays with low to no arrears. We expect the collateral to hold up well this year, as jobless rates are expected to fall slightly in the eurozone and growth is forecast to be strong.
We expect 2022 to see a healthy supply of CLOs, consumer ABS and RMBS, exceeding the 2021 total of EUR 120 billion.
Are there any sectors that you favour in the current environment?
Irrespective of market conditions, we can always find high-quality assets for our portfolios. In this environment, we believe there is particularly good value in car ABS, collateralised loan obligations (CLOs) and residential mortgage-backed securities (RMBS).
We have favoured the car segment of ABS for a while because of its short credit duration with a low weighted average life. Furthermore, these securities are collateralised by physical assets (i.e. the vehicles), so for investors, there is the benefit of exposure to tangible assets.
RMBS has a similar link to tangible assets. We prefer prime RMBS exposed to continental Europe rather than the UK. The UK market is mainly comprised of mortgages with fully variable rates, or rates that are variable after a two-year fixed period. So in the UK, there is greater risk from higher rates.
We favour CLOs, particularly those with underlying corporates that have exposure to Covid resilient sectors. CLOs have done well over the past 12 months, with low defaults.
References
[1] The LCR is designed to ensure that banks hold a sufficient reserve of high-quality liquid assets to allow them to survive a period of significant liquidity stress lasting 30 calendar days. Source: https://www.bis.org/fsi/fsisummaries/lcr.htm
Disclaimer
