Birth of e100bn ABS market
Issuance of European asset-backed securities (ABS) exploded during 1999 to over E75bn, a 60% increase on the previous year. This growth is set to continue. We expect issuance for 2000 to be in the range of E90bn–100bn or more than 6% of total European bond market issuance. This market therefore represents an increasingly important sector that should be considered by investors as part of any bond portfolio. European ABS represent excellent value investments, benefiting from high yield relative to comparably rated investments and strong protection against downgrade and credit event risks.
Securitisation is the process of converting loans, debt obligations and other types of receivables into liquid, tradeable debt instruments. The payment flows collected under these receivables are used to pay interest and principal on the resulting securities. Since the receivables form the main collateral for payments under the securities, the securities are usually known as asset-backed securities.
ABS are typically rated by independent rating agencies, which provides a basis for the assessment of their creditworthiness. ABS may be traded on a secondary market basis and ABS transactions typically obtain high ratings as a result of the transaction structures created.
The receivables can be originated by an industrial company, a bank or a government entity. In a securitisation transaction, the receivables are segregated from the accounts of the originator. Therefore, a securitisation transaction may achieve an off-balance sheet treatment in the originator’s accounts. Furthermore, since the investors in the ABS rely solely upon the creditworthiness of a well-defined pool of assets and cannot have recourse to the originator for the credit performance of the ABS, securitisation is often referred to as a non-recourse financing technique.
In outline, securitisation involves the transfer of receivables from the originator to a different entity. The purchaser of the assets is usually a newly-constituted company, fund or trust whose sole purpose is to acquire the assets and finance their purchase by issuing rated asset-backed securities: the purchaser of the receivables is therefore referred to as a special purpose vehicle (SPV). The SPV is typically thinly capitalised, with its credit strength deriving solely from the assets and any additional credit support. The equity of the SPV is typically provided by a third party, such as a charitable trust, and therefore may be off-balance sheet for the seller.
The SPV purchases the receivables from the originator, financing the acquisition by issuing ABS on the capital markets. The overall ABS issuance may be further split into different tranches which have different ranking in the payment of interest and principal (see Figure 1). For instance, an SPV might issue:
q senior class A notes, privileged in the payment of interest and principal;
q mezzanine class B notes, subordinated to the class A notes with regard to the payment of interest and principal and thereby providing credit enhancement for the class A notes;
q junior class C notes, subordinated to both class A and class B notes and thereby providing credit enhancement for both.
In case the receivables perform less well than expected, impairing the SPV’s ability to pay interest and principal on the ABS, the SPV may deploy certain additional credit support facilities. These might include credit enhancements (such as bank letters of credit, subordinated loans and credit facilities), liquidity lines and derivatives (swaps and caps).
As one of the fastest-growing forms of finance, securitisation is now a feature of most financial markets. The largest and most developed market is in the US, which began in the 1970s with the initiation of government funding programmes for residential mortgages. However, by the end of the 1990s, securitisation had become a global financing tool with public securitisation issues launched in most developed countries and most asset classes the subject of securitisation. Figure 2 shows the growth of the European ABS market since 1990.
In 1999, the largest source of issuance by country of origination was the UK, which accounted for approximately one third of total issuance followed by Germany (15%) and France, Italy and Spain, each accounting for approximately 10%. With respect to asset class, residential mortgage-backed securities (MBS) accounted for approximately one third of total issuance in 1999, followed by collateralised loan obligations (CLOs), with 15%. All other asset classes individually accounted for less than 8% each. We expect no substantial change in the relative importance of individual asset classes or the geographic source of issuance this year, although over the next two or three years, we would anticipate a relative decline in issuance from the UK and increased issuance from a range of countries, notably Germany and Italy. The European ABS market remains an extremely high quality credit market. During 1999, 70% of total European ABS market issuance was AAA-rated with only 8% of issuance rated BBB or below or unrated. The outlook for overall market quality going forward is stable.
The vast majority of European ABS are issued as floating-rate notes (FRNs) and accordingly are priced against Libor/Euribor. During 1999, approximately 92% of European ABS transactions were structured as FRNs. The market continues to see a stream of fixed-rate issuance most notably in the sterling fixed-rate long-dated markets, and the Dutch MBS markets but this will continue to represent a relatively small segment of total issuance.
The benefits of considering European ABS as part of an investment portfolio include:
q Higher yield relative to other comparably rated instruments. The European ABS market is one of the cheapest credit products available on a relative value basis. Although the pricing of individual European ABS issues varies widely according to asset class and maturity, during 1999, AAA-rated ABS with a five-year maturity traded, on average, 50 basis points a year higher than comparable maturity German government bonds and 20bps a year higher than AAA-rated corporate bonds of comparable maturity. Relative spreads for lower-grade credits are significantly higher and, for example, European BBB-rated ABS may, depending on the asset class trade 100–150bps higher than comparably rated five-year corporate credits.
q Reduced credit event risk. The recent downgrading of Mannesmann bonds demonstrated the contingent credit risks inherent in single name investments. Another example of a credit event for a single name issuer in recent years is South Korea. Asset-backed bonds suffer less from event risk as the assets being funded are typically diversified pools from hundreds or even thousands of obligors.
q Reduced downgrade risk. A recent study by Moody’s shows how ABS investments have a substantially greater protection against downgrade events than comparably rated corporate bonds. For example, based on a review of Moody’s rated bonds, less than 80% of corporate bonds that start with an AAA rating remain AAA-rated after five years. For comparable AAA-rated ABS, the figure is in excess of 90%.
Mark Lewis is director of origination and securitisation, asset securitisation, at ABN Amro in London