ABS in a Covid economy
Securitized credit sectors appear to be holding up well so far.
With much of the asset-backed securities (ABS) market based on consumer debt, we asked Senior Portfolio Manager Randy Bauer for an update on how the three-largest ABS sectors—auto, credit card and student loans—are faring as this still-fragile economy recovers.
Despite pandemic worries, auto loans—the largest cohort of consumer-related ABS—are performing better than we expected. Defaults, losses and deferments, while higher than they were prior to the outbreak, have all been lower than anticipated. Keep in mind, we stress test all of our deals to verify their potential to withstand stresses far greater than anything that has occurred to date or could happen if economic conditions deteriorate substantially from here—an outcome we don’t expect. Even with a reduced level of governmental support, we believe the structures in our portfolios should remain stable.
Overall, we view the auto ABS sector as a source of value right now, and the recovery of credit spreads—that is, the difference in yields between auto ABS and the 10-year Treasury—since March seem to indicate many investors share this opinion. As an aside, one very attractive aspect of auto ABS, and one of the reasons we like the sector so much, is it is one of the few asset classes in which non-AAA-rated bonds routinely are upgraded over time due to the combination of security structure and collateral performance.
Credit card ABS securities, especially those issued by highly rated sponsors, historically have been resistant to adverse economic scenarios. We particularly prefer loan pools backed by banks as well as co-branded cards that are not solely dependent on the viability of a particular retailer
While we don’t yet know the full extent of the impact or the length of time consumers will be challenged by this pandemic, the performance of credit card ABS during the 2008 global financial crisis provides a helpful reference point. At that time, credit card ABS trusts experienced periods of elevated delinquencies and charge-offs. Despite that increased stress, structures proved to be robust. Also, compared to the period prior to the 2008 crisis, today’s consumers and trusts appeared to be on better financial footing based on all relevant credit card ABS metrics heading into this crisis.
Based on our assessment of issuers and the underlying assets, we remain comfortable with both the credit card ABS asset class and our specific holdings.
Despite the challenges presented by the pandemic, we remain comfortable with federally insured and private student loan ABS positions in our portfolios. In fact, we believe student loans are uniquely suited to weather difficulties presented by a short-term disruption to the economy. Borrowers have the ability to file for temporary payment suspension via forbearance, which typically is granted for three-month periods and a total of 12 months over the life of the loan. Although interest on the loan continues to accrue during forbearance, the borrower is able to experience immediate payment relief. Forbearance utilization increased across most private student loan pools during April, May and June 2020, but fell significantly in July, indicating that borrowers are beginning to return to more typical behavior.
In addition, underwriting standards appear to have remained high for both refi and in-school student loans. The typical refi student-loan borrower has a graduate or doctorate degree, is a high earner with a high credit score and has been making student loan payments for years. Meanwhile, in-school student loans generally are made to students seeking four-year degrees at not-for-profit institutions, and benefit from the inclusion of a creditworthy cosigner, typically a parent. Over 90% of loans issued to in-school borrowers are underwritten with a cosigner, for which all payment responsibilities are shared. If a recent graduate is unable to find employment sufficient to service his or her student debt, the obligation of the cosigner should mitigate future defaults.
Our federally insured student loan ABS holdings are backed by loans originated under the now-defunct Federal Family Education Loan Program (FFELP). Unlike private loans, FFELP loans were minimally underwritten and disbursed by the federal government, leading to inferior loan pool performance relative to strictly private school loan pools. While this often leads to attention-grabbing headlines, FFELP loans are guaranteed by state agencies and reinsured by the U.S. Department of Education for at least 97% of defaulted principal and interest. When this guarantee is coupled with a deal structure that provides adequate credit enhancement, FFELP student loan ABS bonds, from our perspective, make for a sound investment.