TRUST IS MOVING FORWARD FOR ASSET BACKED SECURITIES
FOLLOWING the onset of the financial crisis in 2008 – and the resulting loss of confidence in the performance of Asset Backed Securities (ABS) – distressed or forced sales led to depressed valuations. Yet the assets themselves suffered few actual defaults – in fact mostly performing as expected. It was the forced selling, or the paper losses due to mark-to-market valuations, that led to this collapse in confidence for this asset class.
Of course, ABS as an asset class presents unique valuation challenges – due in no small part to its reliance on inherently uncertain future cash flows. However, increased investor protection has led to prices recovering to levels not seen since the middle of 2008. Added to this, the strong value offered by ABS bonds compared to other asset classes gives them excellent upside potential, especially in the present low interest rate environment. For example, a “AAA” rated Dutch Residential Mortgage Backed Security with a five-year weighted average life recently traded at a spread of 128 basis points (bps) over three month Euribor, while a corporate bond of similar maturity and rating traded at a spread of just 88 bps.
Furthermore, the opportunity for strong returns has been enhanced for those with a higher risk tolerance. Some “BBB” rated bonds have become heavily discounted due to a growing risk aversion among investors, although some hedge funds have been successfully picking bargains. That said, the gap between senior and subordinated ABS spreads is narrowing, revealing that risk appetite is making a strong return across the ABS asset class.
In fact – and perhaps surprisingly – stability has been one characteristic of the ABS market of late. The sovereign debt crisis and rating downgrades on sovereign bonds have both failed to significantly dent bond prices in European structured finance.
Certainly, the outlook for ABS has significantly improved relative to the pessimism of two years ago, aided by both improving credit performance and amortisation. With higher underwriting standards and more protection for investors, the ABS market looks to have re-secured its long term status as an important funding tool – if still only one for sophisticated investors.
CHALLENGES AHEAD
However, challenges remain. For example, a smarter approach to valuation is required in order to create a more accurate reflection of pricing and value in the ABS market.
Yet as liquidity has returned the volume of market information – encouraging price transparency – has also improved. This includes publications such as Standard & Poor’s Assumptions Survey, an industry-wide perspective on modelling assumptions in European ABS. Furthermore, investors now have the tools available to compare their own views on bond valuations to those produced by the likes of Standard & Poor’s Security Evaluations (SPSE).
Also, cash flow modelling engines such as S&P’s ABSXchange are being adopted by an increasing number of investors to analyse different stress levels on the collateral pools that support ABS issuance and by extension on ABS pricing.
The challenge to fully rebuild investor confidence in the ABS market has yet to be won. Nevertheless, with more advanced risk evaluation, thanks to new loan-level data sets and also more robust analytics entering the market, the long road to recovery in investor confidence seems to be unwinding.