In Brief
- Although we are closely monitoring the health of the consumer and lending standards, we think certain high-quality ABS offer strong credit protection.
- Lower-rated segments of the CLO market may potentially experience downgrades ahead. We believe better opportunities exist in the higher-quality parts of the market.
- We favor well-underwritten, high-quality, and shorter-duration ABS securities and higher-rated CLOs with lower spread volatility.
ABS Market Recap
Consumer asset-backed securities (ABS) faced headline risk throughout much of 2023 behind growing concerns about consumer health in the face of rising interest rates and a potential economic slowdown, as well as a decrease in bank demand. We observed some consumer weakening in the fourth quarter, with a cooling labor market, a decline in household savings, and a rise in delinquencies on various segments of consumer debt.
It is important to note that these negative trends are occurring in the context of multi-year fundamental consumer strength. Income levels, for example, continue to experience growth, building on significant gains since the reshaping of the job market during and after the COVID-19 lockdowns. And although the labor market is showing signs of deceleration, unemployment is still below 4% and only modestly above the 50-year low experienced earlier in 2023. Additionally, a decrease in average retail gasoline prices has provided timely relief, particularly for lower-income consumers. Furthermore, we believe the shift of the U.S. Federal Reserve’s (Fed) focus from price pressures to growth at the end of 2023 may make for an attractive environment for high-quality ABS, particularly given their strong credit protection and diversification.
ABS Outlook: Attractive Relative Value Opportunities Amid Varied Fundamentals
We believe there is a wide dispersion in the fundamentals of 2023 vintage origination that requires careful selection. Some underwriting standards have tightened, while other operators have expected rates to fall, leading to looser standards. Thus, with markets pricing in looser financial conditions in 2024, some lenders may face increased net-interest-margin pressure.
The largest category of ABS—auto loans— has faced a combination of lending standards concerns, declining used vehicle prices, and rising delinquencies. While we expect that auto prices may decline further, and headlines around delinquencies will continue, we believe there is considerable protection in the ABS deal structures, creating pockets of attractive relative value in the current environment.
ABS Positioning: Focusing on Strong Credit Fundamentals
Going forward, we favor well-underwritten, high-quality, and shorter-duration securities. We are focused on deals that have demonstrated robust credit fundamentals, including well-behaved delinquency and loss trends, consistent collateral quality, and strong stress-tested structures. We also believe ABS are providing attractive compensation, with the ABS component of the Bloomberg U.S. Aggregate Bond Index yield-to-worst (YTW) at 4.96% versus the Bloomberg U.S. Aggregate Bond Index YTW of 4.53% as of the end of 2023. Furthermore, given the shorter maturity structure of consumer lending, ABS coupons have adjusted higher much more quickly than the broader high-quality fixed-income market. We find this dynamic attractive as more of investors’ total return potentially may be generated from income, as opposed to price appreciation.
As attractive as the ABS asset class can be, we believe the space is best owned in the context of an actively managed multi-sector portfolio with the flexibility to capture attractive relative value opportunities as they arise.
CLO Market Recap
As we enter the new year, we believe a vigilant approach in the collateralized loan obligation (CLO) market is warranted. Amid this caution, however, we believe there will be pockets of opportunity within the asset class going forward.
Throughout 2023, the CLO market’s supply/demand dynamic was a primary driver of performance, as new loan issuance increased only marginally, while demand by CLO managers remained robust. These conditions bolstered loan prices and compressed spreads over the past twelve months. Considering loans maturing over the next few years, various higher-quality parts of the market were refinanced in 2023, while lower-rated borrowers had more difficulty, leading to potential downgrades going forward.
CLO Outlook: Maintaining Vigilance and Underscoring Credit Quality
CLO Positioning: Emphasizing Collateral Quality
Figure 1. Lower Spread Volatility Among Higher-Quality CLOs Signals an Opportunity
About the Contributors
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Glossary & Index Definitions
The U.S. Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.
Asset-backed security (ABS) is a security whose income payments and value are derived from and collateralized by a specified pool of underlying assets.
Collateralized loan obligations (CLO) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches.
The J.P. Morgan Collateralized Loan Obligation Index (CLOIE) is the first total return benchmark for broadly syndicated arbitrage U.S. CLO debt. It is comprised of U.S. dollar denominated broadly syndicated arbitrage CLOs.
A basis point is one one-hundredth of a percentage point.
The capital stack, or capital structure, refers to the layers of debt and equity capital used by companies to finance operations.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.
Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.
Bloomberg Index Information
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