European asset-backed securities (ABS) are trading at historically attractive levels compared to similarly-rated corporate and government bonds, paradoxically because many see these instruments in connection with the 2008 financial crisis, explained Matthew Wardle, who makes the case for investment-grade structured credit in his role as M&G’s ABS portfolio manager.
Certain banks and insurance companies still need to be convinced about ABS. However, European ABS are very tightly regulated and have long been stronger performers than their US equivalents, he pointed out.
“We think if you were to assess the market opportunity purely based on credit risk, the ABS market should trade at tighter spreads than it does today and has done over recent years,” said Wardle in a recent Investment Officer interview. “We think that the reason the yields are as wide as they are is the relatively harsh regulation for ABS in Europe post-GFC compared to other asset classes.
ABS fund launch
Wardle, who heads a team of “almost 20” focused on ABS/structured credit that invests in Europe and elsewhere in the world, was in Luxembourg recently to make the case for ABS but also to support the launch of a forthcoming new ABS fund: the M&G Investment Grade ABS Fund. “We feel this product is going to allow us is the opportunity to talk about ABS to a wider range of investors than has been the case before,” explained Wardle.
The fund is to be launched against a backdrop of increased supply of ABS, with increased volumes this year, explained Wardle (see graphic below). In May 2024, some 20 billion euro was issued—a post-GFC monthly record. He said he expects this trend to continue to outstrip the record of recent years.
While ABS’s wider spreads appear attractive, the gap reflects the difficulty of investing for significant elements of the investor base, Wardle explained. “Regulation for certain investors in the market, banks and insurance companies, in particular, the cost of capital or capital charge for them to invest in ABS compared to other markets is very significant.”
Solvency II
More recently, he explained “what has happened is pension funds, family offices, other institutional investors who aren’t governed by the Solvency II capital charges for ABS and for insurance companies, for instance, have looked at the track record of the ABS market, particularly in Europe over the past 10 to 15 years,” he said. These firms, he added, have “concluded that performance has been very strong, taken a lot of comfort from the stress resiliency of the asset class.”
He stated that another aspect of the ABS market that is appealing compared to what happened during the financial crisis is the quality of collateral in recent years compared to what happened before.
“The loan to values that banks originate mortgages at in recent years is far lower than it was before the GFC across a variety of jurisdictions.” Assessments of the credit quality of borrowers are much higher post-GFC.
More upgrades
Wardle says M&G has a lot of data showing that consistently on an annual basis over the past 10 years, “you’ve seen more upgrades than downgrades in ABS consistently compared to financial and non-financial corporates.”
According to Wardle, “there’s a huge body of evidence which supports ABS being a high quality, predictable and defensive asset class.
It has taken a while for pension funds, family offices, etc to educate themselves sufficiently to get comfortable with ABS, Wardle explained. “But once they’ve done that, they are typically investing in the market and taking advantage of this regulatory disparity, which continues to exist.”
Reflecting on crisis
“There’s a number of people in the investment community who if you asked them to talk about ABS would relatively quickly reflect on the US subprime market during the GFC,” Wardle explained. However, he pointed to the difference between the US and Europe in asset-backed securities.
“There was a big difference between the US and the European market during the GFC,” said Wardle. One of the major factors is “the difference in mortgage enforceability between the US and Europe.”
He explained that in the US if your house’s value falls below the value of your mortgage, you can simply hand the keys back to the bank.
Personal guarantee
In Europe, by contrast, taking out a mortgage involves giving a personal guarantee. The legal situation allows the bank to go after a defaulting mortgage holder to obtain repayment from the defaulter’s savings and other sources of capital.
“That sort of difference is often not appreciated in terms of going a pretty significant way to explaining the difference in performance between the two markets,” said Wardle.
Europeans, said Wardle, “are in our opinion much more motivated to maintain that mortgage payment”. This, he explains, has been true historically and “in more recent times”.
