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Asset-Backed Securities: A Safe Haven from Market Turmoil

The ABS sector combines high quality, short maturity, strong liquidity and attractive yields.

By Jeff Brothers

The outlook for the financial markets has turned cloudier over the past couple of weeks. Investors seeking an alternative from the gloom of recent markets should look at the asset-backed securities sector, an area within the fixed income market that we believe still has clear skies.

In our opinion, the ABS sector offers a compelling safe haven from the market turmoil with a combination of high quality, short maturity, strong liquidity and attractive yields. ABS is a unique fixed income asset class with the bonds secured typically by consumer-related collateral, such as auto loans, credit card receivables or student loans. ABS is a developed market with approximately $700 billion in outstanding bonds and over $200 billion in gross annual issuance. The sector has historically provided attractive risk-adjusted returns and yields ranging between 3 percent and 3.5 percent depending on the asset type, maturity and rating. 

The Case for ABS Starts with the Sector’s Positive Fundamentals

The collateral backing the securities continues to benefit from the overall strength of the U.S. economy and from healthy consumer finances. In particular, consumer credit trends are primarily influenced by the strength of the labor markets, which have added close to 2.4 million jobs over the past year and the unemployment rate hit a 48-year low of 3.8 percent. Record increases in consumer net worth from stock gains and home price appreciation also support consumer fundamentals. In addition, the recent tax cuts should provide additional disposable income to service consumer debt. Lastly, although absolute consumer debt levels have been gradually rising, measures like debt-to-income and the debt-service ratio, highlight the healthy state of consumer balance sheets. Unlike during the financial crisis, the lending excesses in today’s economy appear concentrated on corporate rather than the consumer balance sheets.

Time Tested Support of ABS Structure a Key Positive

Despite the positive fundamental picture, we have seen some increases in delinquencies and charge-offs across the ABS collateral types. This modest deterioration in credit trends warrants monitoring, but in general it’s coming off historically low levels, remains within underwriting expectations and most important is supported by the robust structural protections with the ABS securitization.

The strength and time-tested support provided by the ABS structure is a key positive factor for the sector, even in the face of some softening in the underlying credit trends. Consumer ABS structures held up extremely well through the very stressful Great Recession. Even in the much maligned subprime auto sector, bonds rated AAA and AA experienced no principal loss during the crisis, and investment grade bonds, according to Moody’s, have a historical impairment rate of only 0.1 percent. The bond structures utilize robust credit enhancement and deal triggers to protect investors against potential principal loss and redirect cash flows if credit trends deteriorate.

As the outlook for the financial markets becomes cloudier, we believe the ABS sector with its high quality, short maturities and attractive yields is a solid choice to ride out the storm.

Jeff Brothers is the Senior Credit Portfolio Manager at Tortoise.

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