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about our fixed income capabilities
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about our fixed income capabilities
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to receive future insights
Read more about our future ESG ambitions
ESG
Source:
M&G, March 2022
Our ESG journey stretches back more than two decades to the founding of our in-house ABS credit research team.
Over the years, our approach has become increasingly rigorous incorporating sophisticated ESG analysis throughout the investment process.
Our recent achievements include the completion of our proprietary ESG Structured Credit Scorecard and our emissions estimation modelling of the auto ABS sector. In the coming period, we aim to continue developing more advanced carbon modelling and to incorporate further data into our proprietary research systems.
Key milestones
Early
2000s
Early
2000s
2008
2008
2013
2013
2019
2019
2020
2020
2021
2021
Q1
Q1
Q2
Q2
Q3/Q4
Q3/Q4
2022
and beyond
and beyond
2022
CLOs
SRTs
Platform financing
CLOs
SRTs
Platform financing
Time
1
Closing date
2
3
End of investment period
4
Collateral balance
Effective date
Initially, the CLO manager begins to accumulate the collateral pool while appointing an investment bank to market the CLO to interested parties. Third-party investors may provide financing to the CLO manager during the warehouse period in exchange for the excess spread on the loans purchased. Warehouse investors typically have the option to remain invested in the equity tranche of the deal, often with a controlling stake.
1. Financing the warehouse
(warehouse period)
At this stage, the CLO tranches will be marketed by the arranger (investment bank). Orders are processed and allocated to investors between the pricing and closing dates. Following this, there will be a final ramp-up phase to allow the manager to finish initial portfolio construction, with interest already beginning to accrue at this point.
2. New issue of tranched securities
During this period, the CLO manager will typically be actively trading in the portfolio. The deal is usually non-callable for the first 18-24 months after the closing date. However, once the non-call period ends, the equity investors have the option to call, refinance or reset the CLO to improve the terms of their arbitrage.
If a CLO is refinanced, there is no change to the collateral pool or terms of the deal, but all debt tranches are called and then re-issued (usually at lower financing costs). In a CLO ‘reset’, the debt tranches are also called and re-issued. However, the terms of the overall deal may change. For example, the reinvestment period can be extended by a number of years.
3. Re-investment period
Once the re-investment period ends, there is little active trading and the cashflows/principal repayments from the collateral are used to pay down the debt tranches sequentially.
4. Amortisation period
CLOs
The varied lifecycle of a CLO offers different types of potential opportunities. Early-stage investments can provide access to a diversified pool of loans and quick repayment for noteholders. Alternatively, end-stage CLO lifecycle investing during the amortisation period gives greater certainty of the overall risk profile of the security based on a static pool of assets (given the manager’s inability to trade) and a shorter, non-flexible maturity date.
Please click on the chart below to learn more about potential opportunities across the CLO lifecycle.
Key stages in a CLOs lifecycle
"If a CLO is refinanced, there is no change to the collateral pool or terms of the deal."
Source:
Deloitte, "CLO Structures - An Evolution". For illustration purposes only. Information is subject to change and is not a guarantee of future results.
What are SRT transactions?
A significant risk transfer (SRT) transaction is first- or second-loss (mezzanine) protection purchased by a bank on a diversified pool of core lending assets, for example corporate loans (whether loans to medium and large-sized corporates or SME loans), personal loans and auto loans.
"SRT transactions have largely come about as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of loan assets."
Source:
M&G, March 2022. For illustration purposes only. Information is subject to change and is not a guarantee of future results.
Over the years, this type of transaction has become more common. Since the global financial crisis, banks have faced tighter and more onerous regulatory capital requirements, imposed by accounting standards and regulations such as IFRS 9 and Basel III (and Basel IV to follow), which have effectively impeded banks’ capacity to lend and boost their revenues, as bank lending creates risk-weighted assets with an associated capital requirement.
Therefore, SRT transactions have largely come about as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of the loan assets from a regulatory perspective, without having to de-recognise assets on the balance sheet. In other words, synthetic securitisation like SRT provides an effective way for banks to engage in risk-sharing transactions with non-bank investors without needing to raise equity or sell assets.
The structure of a typical SRT deal
1) Bank buys protection on the first/second loss tranche
What’s the potential opportunity?
SRT transactions can be highly income-generative, offering potentially high single-digit or low double-digit coupons. They also offer investors access to a diversified range of otherwise hard-to-access assets, including consumer and corporate loans, which represent the core lending activity of top-tier retail banks. Deals can also be highly customised, given the extensive negotiation and due diligence undertaken in each transaction.
Investors can request specific exclusions on the basis of credit quality, sectoral preferences and ESG concerns. The ability to set these parameters upfront can help to ensure that the default rates in SRT reference portfolios are typically lower than overall bank balance sheets.
The vast majority of SRT transactions have been issued by European banks; however, a growing number of US banks are beginning to access this market. We anticipate higher volumes issuance from the US over the coming years.
2) Investor receives a floating rate coupon
Reference portfolio of bank loans
Detach
6.00%
Attach 0.00%
Retained
Retention of 5% of each loan
Placed
Bank portfolio
of assets
Investor
buys CLN
Collateral
account
Issuer (SPV)
Issues Credit Linked Notes (CLN) referencing first/second loss portion of portfolio and provides protection against defaults in the porfolio
Cash
proceeds
Cash
proceeds
Coupon
Pays
protection
premium
Pays collateral interest
CDS provides protection against defaults in portfolio
"Reference portfolio"
What is platform financing?
Platform financing involves funding innovative, non-bank lending platforms, typically at the senior and mezzanine level, using the underlying loans generated as collateral for secured asset-backed loan facilities. Non-bank lending platforms typically serve smaller corporate borrowers (SMEs) and certain consumer lending verticals that tend to be overlooked by traditional lenders like banks, due to the punitive bank regulatory capital charges associated with this type of loan origination activity.
Over recent years, fintech platforms have been making inroads in certain lending segments, including SME lending alongside private debt and direct lending funds, and are helping to both disrupt and transform the lending landscape that has been traditionally dominated by large, retail banks. Overall, the volumes originated by fintech lenders remain comparatively small but are growing very rapidly, leading to greater and more diversified opportunities for investors looking at the asset class.
A number of non-bank lending platforms have emerged that focus on newer forms of SME lending, such as business credit cards, trade and working capital (receivables finance), and asset finance (equipment leasing), rather than overdrafts, term lending and capex loans, which remain the domain of banks’ relationship lending. Platforms supporting underserved borrowers could also offer exposure to megatrends or future growth drivers, including the future of work (freelancer receivables financing) or the internet of things.
These assets are often secured and short-term in nature, lending themselves well to traditional asset-backed financing structures, with securitisation providing more efficient funding.
Big data and technology: From a credit perspective, these platforms often have access to better and more accurate data sources (eg ecommerce data, behavioural data)
Serving the underserved: Access to lending segments where banks have retrenched including from capital-intensive or too-esoteric segments (eg trade finance)
Innovative business models: Better understanding of customer needs (eg streamlined loan application processes, better UX, specialty lending).
A new, disruptive asset class
The global fintech market is experiencing rapid growth
What’s the potential opportunity?
"Platforms supporting underserved borrowers could offer exposure to megatrends or future growth drivers."
Source:
M&G, as at August 2021. 1Data from Credit Suisse, Deloitte, Mordon Intelligence paper.
High yield
Source:
CLOs: Citi. SRTs and platform financing: M&G, as at March 2022. The source of the information is M&G experience of trading in the market. Information is subject to change and is not a guarantee of future results.
There is a wide variety of high yield European ABS. In this guide, we focus on the most prevalent types, namely junior and mezzanine collateralised loan obligations (CLOs); significant risk transfer (SRT) transactions; and platform financing. These are fixed income asset classes where perceived structural ‘complexity’ has been considered as a potential barrier to wider investment and understanding, although we often find that complexity can be a source of return premium for those willing to manage it.
An overview of non- lG structured credit asset classes
Collateralised loan
obligations
Significant risk
transfer transactions
Platform
financing
Market overview
Target returns
Underlying collateral
Liquidity profile
€1 trillion market, primarily US: $848 billion in the US and €178 billion in Europe
A growing market, c.€8-10 billion SRT transactions issued annually over last three years
Rapidly growing area of non-bank lending. Estimated to be around $125 billion today, of which $23 billion is European
Leveraged loans
Corporate loans, trade finance,capital calls, specialised lending, consumer finance and even commercial real estate
SME or consumer loans
Primarily public with an active secondary market
Predominantly private but with some secondary liquidity
Private only
BB/B-rated debt tranches tend to offer a significant yield premium over equivalent corporate debt
Equity tranches can offer low double-digit target IRRs
Target IRRs are typically high single digit to low double-digit range
Low teen target IRRs, from a combination of first-loss and mezzanine lending, primarily
Investment
grade
Features
Structural resilience
The majority of outstanding ABS issuance is rated as investment grade (IG) and can be split into two categories:
The majority of outstanding ABS issuance is rated as investment grade (IG) and can be split into two categories:
Senior
Senior ABS are typically rated AAA due to the credit enhancement created by securitisation and represent the largest and most liquid part of the public ABS market, with secondary market volumes offering the potential liquidity for daily trading, even in stressed conditions, such as the COVID-19 crisis in March 2020. They normally offer a significant yield premium above cash and cash-like assets, which means they are potentially attractive for investors seeking to reallocate some of their cash holdings for at least 6-12 months.
High grade
The broader investment grade market, which includes AA, A and BBB rated securities, comprises mainly mezzanine tranches that sit between senior and junior debt. These tranche sizes are smaller than for senior bonds, which means they are better suited for investors with a medium-term investment horizon of at least 2-3 years. They are less liquid than senior bonds due to their relative scarcity, and typically offer a yield premium.
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Stress test example: UK RMBS
ABS structures offers several layers of protection to senior and mezzanine bondholders, as junior tranches absorb losses first. The chart below shows how a representative* AAA and AA UK RMBS transaction could be expected to withstand extreme market conditions.
What needs to happen before the first percent of principal loss is imposed on these RMBS bonds:
1. An immediate 40% fall in house prices with no recovery ever
and
2. Prepayment to drop to 5%
and
3. Over 70% of homeowners would need to default cumulatively for the AAA tranche to be impacted - over 55% for the AA
Structural resilience
AAA European ABS structural resilience
Source:
M&G Investments, Bloomberg, Intex, 9 March 2021.
Note: Constant default rates (CDRs) are annualised figures
In this scenario, we have modelled an immediate UK house price fall of 40% with no recovery. This compares to the largest actual price decline on record of 18%. The UK Prime RMBS in the chart yields c.0.8%. For this security to lose the first £1/€1 invested, assuming prepayments drop to 5%, over 55% of homeowners would need to default to impact the AA tranche and over 70% to impact the AAA holders. The unprecedented levels of stress in this model compare to the UK’s peak historical repossession rate of 0.79% pa in 1992, a period of elevated unemployment and interest rates reaching 15%. In other words, we believe RMBS can offer a high level of protection against potential risks.
*This analysis is, in our view, representative of the UK Prime RMBS deals within the investable universe of our senior ABS strategies, based on our ongoing analyses of deals that come to market. We believe this analysis is supported by third-party research. In December 2020, FitchRatings performed a scenario analysis in its research paper, UK RMBS Stress Test: Ratings Resilient to Protracted Pandemic Forbearance, when the UK’s COVID-19 lockdown restrictions and mortgage payment holidays were still in place. No AAA or AA tranche defaulted in any of its modelled scenarios. In our view, the stress test shown above reflects more onerous conditions than those used in the FitchRatings analysis, as we have modelled no house price recovery, in contrast to FitchRatings’ assumed recovery periods of 24-60 months. Please note that modelled returns do not reflect actual trading and may not reflect the impact that material economic and market factors may have on decision-making and managing client funds.
Source:
Bloomberg, 31 March 2022. UK Prime RMBS transaction originally issued in August 2017.
Improving credit quality
Example UK Prime RMBS
August 2017
March 2021
Rating
Aa1/AA
AAA/AAA
Credit enhancement
12.0%
56.8%
Credit enhancement example: UK RMBS
Credit enhancement is the structural protection provided to investors, principally from the presence of bonds that are more junior in the capital structure
Increased credit enhancement and strong collateral performance can result in rating upgrades for mezzanine and junior bonds, as the credit quality of these bonds improves through their life
As borrowers in the mortgage pool repay, the transaction structure is deleveraged – this is because borrowers are regularly reducing the size of their outstanding mortgage principals, which decreases the LTVs on the property collateral and hence lowers default risks
As senior bondholders are repaid first, more of the remaining cashflows become available to mezzanine and junior bondholders over time
98% of rating changes for investment grade tranches of UK RMBS transactions over the last 5 years have been upgrades
*The % of credit enhancement broadly refers to the value of the RMBS transaction that must default before the tranche begins to incur losses. This typically includes the value of underlying collateral, as well as the cash reserve account, excess spread (loan repayments exceeding the amount due on RMBS bond coupons) and other structural transaction features.
"Historically, the credit quality of ABS has improved over time, as the underlying loan pool is deleveraged and senior bondholders are repaid."
Source:
M&G, ICE, Bloomberg, 30 June 2022. 1. (£) Sterling Overnight Index Average (SONIA), (€) EURIBOR, ($) Secured Overnight Financing Rate (SOFR), (¥) Tokyo Overnight Average Rate (TONAR) 2. Gross yield on £/€/$ Morgan Stanley Money Market Funds, ¥ JPY 3 Month Deposit 3. Yield to worst for the senior (A) tranches of all outstanding UK Prime RMBS transactions issued during the past five years, which are ineligible for ECB asset purchasing programmes and therefore, in our view, representative of yields available on these securities.
Yield premium
Yields on cash and liquid, defensive assets
Investment grade ABS have historically provided a consistent yield premium over equivalently rated government and corporate bonds, which we believe is maintained primarily by structural market forces that limit the number of potential buyers of these assets.
Past performance is not a guide to future performance.
"Nulla risus nulla, elementum in condimentum vitae, ullamcorper id erat. Aenean posuere, eros et gravida egestas."
£
Cash deposits (1)
1.19%
Money market funds (2)
1.11%
Floating rate European AAA ABS (3)
2.55%
€
-0.20%
-0.52%
0.80%
$
1.50%
1.33%
3.17%
¥
-0.03%
-0.13%
1.05%
Source:
Bloomberg Pan European Floating ABS Bond Index TR Hedged GBP, ICE BofA – UK Gilts All Stocks Index (GAL0), US Treasury Index (G0Q0), German Government Index (G0D0), US Corporate Index (C0A0), Sterling Non-Gilt Index (UN00), Euro Corporate Index (ER00), 31 December 2021. All returns in local currencies.
Low duration
Floating rate AAA European ABS outperform investment grade bonds in 2021
The floating rate coupons paid by ABS can protect against interest rate rises, which are expected in major economies, including the eurozone, UK and US. This has led to recent outperformance from floating rate assets, such as investment grade ABS, compared to traditional government and corporate bonds, as the latter are vulnerable to capital losses from rising interest rates due to their duration risks.
Structural resilience
Improving credit quality
Yield premium
Low duration
Structural resilience
Improving credit quality
Yield premium
Low duration
Why invest in European ABS?
How do ABS work?
Who issues ABS?
2021 European distributed issuance Volume (€bn)
How are ABS created?
Capital structure
How are ABS created?
"Nulla risus nulla, elementum in condimentum vitae, ullamcorper id erat. Aenean posuere, eros et gravida egestas."
Asset-backed securities (ABS) are credit instruments (bonds) secured against a collective pool of underlying assets. These assets are usually loans of a similar type, such as mortgages or consumer and small business loans, which produce regular interest payments.
ABS therefore provide cashflows from loans that would be more difficult to trade individually, which offers investors new potential opportunities.
They have distinct protective features, including the way bond issues are structured, as well as the possibility to recoup losses via claims on specific collateral, such as a mortgaged property or a business’s assets.
ABS are created through a process called securitisation. The underlying assets are collectively pooled inside a bankruptcy-remote special purpose vehicle (SPV). A sponsor, such as a bank or mortgage lender, then creates new bonds, which are secured against the collective asset pool, and issues the bonds to investors. The bonds are split into ‘tranches’ that represent their seniority in the transaction’s capital structure, usually categorised as senior, mezzanine, junior and residual (equity) tranches.
Cashflows from the collective asset pool are distributed via a ‘waterfall’, which means bonds in senior tranches receive payments first. Once these payments to senior bondholders are fulfilled, investors in the tranche below receive their payments. Meanwhile, losses flow upwards, which means the most junior tranches incur losses first. Senior tranches only incur losses once junior tranches have defaulted.
The main issuers of ABS are financial institutions, notably banks, which use securitisation as a funding and de-risking tool. When these institutions lend to consumers and businesses, it may involve large amounts of money and take varying amounts of time to be repaid. By pooling the assets and selling them to investors, the institutions receive new money to lend to borrowers.
Source:
M&G, June 2022. For illustrative purposes only.
Source:
Source: M&G illustrative.
M&G, Deutsche Bank ABS outlook 2022. J.P.Morgan International ABS Spreadsheet (excluding CLOs) DB CLO Premier as of 31 December 2021, unable to define geographical location.
ABS
notes
created...
...and
tranched
ABS
notes
issued/sold...
…in
exchange for
investment
capital
True
sale of
assets
Cash
received
(lender can
now create
more loans)
AAA
BBB
BBB
BB
B
EQUITY
AA
A
Pool of
assets
(Loans)
Investors
Special
purpose
vehicle
(SPV)
Returns on the assets repay the low-risk bonds first
Floating rate coupons
Floating rate coupons
Structural resilience
Structural resilience
Spread premium
Spread premium
ABS coupons are often linked to prevailing cash rates, such as SONIA and EURIBOR, which means their potential income will increase if central banks raise interest rates.
This also effectively removes duration risks, which protects investors’ capital if bond yields rise.
Floating rate coupons
ABS provide multiple layers of credit protection. Robust deal structures, which include ‘credit enhancement’ through debt subordination; over-collateralisation; excess spreads; and strong underlying asset fundamentals all contribute to their resilience.
This is evidenced by low default rates in Europe. For instance, European residential mortgage-backed securities (RMBS) have an average long-term default rate of just 0.3%pa across all credit ratings, which includes investment grade and high yield debt.
Structural resilience
Source: S&P Global, 13 May 2021. Data range: 1983-2020.
ABS have historically provided a consistent spread premium over equivalently rated corporate bonds, which can help to reduce the effects of inflation on incomes.
We believe this premium is mainly caused by structural market dynamics, which reduce the number of eligible investors in the asset class.
Spread premium
Income and capital then flow down
Any capital losses flow up; riskiest bonds bear losses first
AAA
AA
A
BBB
BB
B
Equity
A guide to European asset-backed securities
Higher inflation, rising interest rates and geopolitical risks are leading many investors to diversify their fixed income portfolios away from traditional government and corporate bonds.
We believe European structured credit, also known as asset-backed securities (ABS), could be a potential solution to help investors navigate a more uncertain investment environment.
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
2020
ESG in ABS framework established
Relevant and material ESG factors identified across major ABS sectors
2021
ESG in ABS scorecard under development
Designed to score material ESG factors and map to M&G’s scorecards for corporates and sovereigns
2013
M&G signs up to UNPRI
ESG formalised as part of our ABS credit research
2019
ESG dashboards
Evidence: ESG #themes in Research allows ESG interactions to be monitored across all credit research
Early 2000s
Development of ABS credit research team
Governance and transaction factors always considered in deal analysis
2008
Avoid poor underwriting in the run up to the global financial crisis
Our identification of poor lending standards in areas such as US residential mortgages and European property lending enabled us to largely avoid credit issues during the GFC
Q2/2021
M&G contributed to UNPRI’s first ever paper on ESG integration within securitisations
Q1/2021
Emissions modelling
Work begins to model carbon emissions of Auto ABS Pools
2022 and beyond
Refinement of scorecard/ emissions data
Find out more
about our fixed income capabilities
Find out more
about our real estate capabilities
Subscribe
to receive future insights
Subscribe
to receive future insights
Read more about our future ESG ambitions
ESG
Source:
M&G, March 2022
Our ESG journey stretches back more than two decades to the founding of our in-house ABS credit research team.
Over the years, our approach has become increasingly rigorous incorporating sophisticated ESG analysis throughout the investment process.
Our recent achievements include the completion of our proprietary ESG Structured Credit Scorecard and our emissions estimation modelling of the auto ABS sector. In the coming period, we aim to continue developing more advanced carbon modelling and to incorporate further data into our proprietary research systems.
Key milestones
Early
2000s
Early
2000s
2008
2008
2013
2013
2019
2019
2020
2020
2021
2021
Q1
Q1
Q2
Q2
Q3/Q4
Q3/Q4
2022
and beyond
and beyond
2022
CLOs
SRTs
Platform financing
CLOs
SRTs
Platform financing
Source:
Deloitte, "CLO Structures - An Evolution". For illustration purposes only. Information is subject to change and is not a guarantee of future results.
Time
1
Closing date
2
3
End of investment period
4
Collateral balance
Effective date
Initially, the CLO manager begins to accumulate the collateral pool while appointing an investment bank to market the CLO to interested parties. Third-party investors may provide financing to the CLO manager during the warehouse period in exchange for the excess spread on the loans purchased. Warehouse investors typically have the option to remain invested in the equity tranche of the deal, often with a controlling stake.
1. Financing the warehouse
(warehouse period)
At this stage, the CLO tranches will be marketed by the arranger (investment bank). Orders are processed and allocated to investors between the pricing and closing dates. Following this, there will be a final ramp-up phase to allow the manager to finish initial portfolio construction, with interest already beginning to accrue at this point.
2. New issue of tranched securities
During this period, the CLO manager will typically be actively trading in the portfolio. The deal is usually non-callable for the first 18-24 months after the closing date. However, once the non-call period ends, the equity investors have the option to call, refinance or reset the CLO to improve the terms of their arbitrage.
If a CLO is refinanced, there is no change to the collateral pool or terms of the deal, but all debt tranches are called and then re-issued (usually at lower financing costs). In a CLO ‘reset’, the debt tranches are also called and re-issued. However, the terms of the overall deal may change. For example, the reinvestment period can be extended by a number of years.
3. Re-investment period
Once the re-investment period ends, there is little active trading and the cashflows/principal repayments from the collateral are used to pay down the debt tranches sequentially.
4. Amortisation period
CLOs
The varied lifecycle of a CLO offers different types of potential opportunities. Early-stage investments can provide access to a diversified pool of loans and quick repayment for noteholders. Alternatively, end-stage CLO lifecycle investing during the amortisation period gives greater certainty of the overall risk profile of the security based on a static pool of assets (given the manager’s inability to trade) and a shorter, non-flexible maturity date.
Please click on the chart below to learn more about potential opportunities across the CLO lifecycle.
Key stages in a CLOs lifecycle
"If a CLO is refinanced, there is no change to the collateral pool or terms of the deal."
What are SRT transactions?
A significant risk transfer (SRT) transaction is first- or second-loss (mezzanine) protection purchased by a bank on a diversified pool of core lending assets, for example corporate loans (whether loans to medium and large-sized corporates or SME loans), personal loans and auto loans.
"SRT transactions have largely come about as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of loan assets."
Source:
M&G, March 2022. For illustration purposes only. Information is subject to change and is not a guarantee of future results.
Over the years, this type of transaction has become more common. Since the global financial crisis, banks have faced tighter and more onerous regulatory capital requirements, imposed by accounting standards and regulations such as IFRS 9 and Basel III (and Basel IV to follow), which have effectively impeded banks’ capacity to lend and boost their revenues, as bank lending creates risk-weighted assets with an associated capital requirement.
Therefore, SRT transactions have largely come about as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of the loan assets from a regulatory perspective, without having to de-recognise assets on the balance sheet. In other words, synthetic securitisation like SRT provides an effective way for banks to engage in risk-sharing transactions with non-bank investors without needing to raise equity or sell assets.
The structure of a typical SRT deal
1) Bank buys protection on the first/second loss tranche
What’s the potential opportunity?
SRT transactions can be highly income-generative, offering potentially high single-digit or low double-digit coupons. They also offer investors access to a diversified range of otherwise hard-to-access assets, including consumer and corporate loans, which represent the core lending activity of top-tier retail banks. Deals can also be highly customised, given the extensive negotiation and due diligence undertaken in each transaction.
Investors can request specific exclusions on the basis of credit quality, sectoral preferences and ESG concerns. The ability to set these parameters upfront can help to ensure that the default rates in SRT reference portfolios are typically lower than overall bank balance sheets.
The vast majority of SRT transactions have been issued by European banks; however, a growing number of US banks are beginning to access this market. We anticipate higher volumes issuance from the US over the coming years.
2) Investor receives a floating rate coupon
Reference portfolio of bank loans
Detach
6.00%
Attach 0.00%
Retained
Retention of 5% of each loan
Placed
Bank portfolio
of assets
Investor
buys CLN
Collateral
account
Issuer (SPV)
Issues Credit Linked Notes (CLN) referencing first/second loss portion of portfolio and provides protection against defaults in the porfolio
Cash
proceeds
Cash
proceeds
Coupon
Pays
protection
premium
Pays collateral interest
CDS provides protection against defaults in portfolio
"Reference portfolio"
What is platform financing?
Platform financing involves funding innovative, non-bank lending platforms, typically at the senior and mezzanine level, using the underlying loans generated as collateral for secured asset-backed loan facilities. Non-bank lending platforms typically serve smaller corporate borrowers (SMEs) and certain consumer lending verticals that tend to be overlooked by traditional lenders like banks, due to the punitive bank regulatory capital charges associated with this type of loan origination activity.
Over recent years, fintech platforms have been making inroads in certain lending segments, including SME lending alongside private debt and direct lending funds, and are helping to both disrupt and transform the lending landscape that has been traditionally dominated by large, retail banks. Overall, the volumes originated by fintech lenders remain comparatively small but are growing very rapidly, leading to greater and more diversified opportunities for investors looking at the asset class.
A number of non-bank lending platforms have emerged that focus on newer forms of SME lending, such as business credit cards, trade and working capital (receivables finance), and asset finance (equipment leasing), rather than overdrafts, term lending and capex loans, which remain the domain of banks’ relationship lending. Platforms supporting underserved borrowers could also offer exposure to megatrends or future growth drivers, including the future of work (freelancer receivables financing) or the internet of things.
These assets are often secured and short-term in nature, lending themselves well to traditional asset-backed financing structures, with securitisation providing more efficient funding.
Big data and technology: From a credit perspective, these platforms often have access to better and more accurate data sources (eg ecommerce data, behavioural data)
Serving the underserved: Access to lending segments where banks have retrenched including from capital-intensive or too-esoteric segments (eg trade finance)
Innovative business models: Better understanding of customer needs (eg streamlined loan application processes, better UX, specialty lending).
A new, disruptive asset class
The global fintech market is experiencing rapid growth
What’s the potential opportunity?
"Platforms supporting underserved borrowers could offer exposure to megatrends or future growth drivers."
Source:
M&G, as at August 2021. 1Data from Credit Suisse, Deloitte, Mordon Intelligence paper.
High yield
Source:
CLOs: Citi. SRTs and platform financing: M&G, as at March 2022. The source of the information is M&G experience of trading in the market. Information is subject to change and is not a guarantee of future results.
There is a wide variety of high yield European ABS. In this guide, we focus on the most prevalent types, namely junior and mezzanine collateralised loan obligations (CLOs); significant risk transfer (SRT) transactions; and platform financing. These are fixed income asset classes where perceived structural ‘complexity’ has been considered as a potential barrier to wider investment and understanding, although we often find that complexity can be a source of return premium for those willing to manage it.
An overview of non- lG structured credit asset classes
Collateralised loan
obligations
Significant risk
transfer transactions
Platform
financing
Market overview
Target returns
Underlying collateral
Liquidity profile
€1 trillion market, primarily US: $848 billion in the US and €178 billion in Europe
A growing market, c.€8-10 billion SRT transactions issued annually over last three years
Rapidly growing area of non-bank lending. Estimated to be around $125 billion today, of which $23 billion is European
Leveraged loans
Corporate loans, trade finance, capital calls, specialised lending, consumer finance and even commercial real estate
SME or consumer loans
Primarily public with an active secondary market
Predominantly private but with some secondary liquidity
Private only
BB/B-rated debt tranches tend to offer a significant yield premium over equivalent corporate debt
Equity tranches can offer low double-digit target IRRs
Target IRRs are typically high single digit to low double-digit range
Low teen target IRRs, from a combination of first-loss and mezzanine lending, primarily
Investment
grade
Features
Structural resilience
The majority of outstanding ABS issuance is rated as investment grade (IG) and can be split into two categories:
Senior
Senior ABS are typically rated AAA due to the credit enhancement created by securitisation and represent the largest and most liquid part of the public ABS market, with secondary market volumes offering the potential liquidity for daily trading, even in stressed conditions, such as the COVID-19 crisis in March 2020. They normally offer a significant yield premium above cash and cash-like assets, which means they are potentially attractive for investors seeking to reallocate some of their cash holdings for at least 6-12 months.
High grade
The broader investment grade market, which includes AA, A and BBB rated securities, comprises mainly mezzanine tranches that sit between senior and junior debt. These tranche sizes are smaller than for senior bonds, which means they are better suited for investors with a medium-term investment horizon of at least 2-3 years. They are less liquid than senior bonds due to their relative scarcity, and typically offer a yield premium.
Stress test example: UK RMBS
ABS structures offers several layers of protection to senior and mezzanine bondholders, as junior tranches absorb losses first. The chart below shows how a representative* AAA and AA UK RMBS transaction could be expected to withstand extreme market conditions.
What needs to happen before the first percent of principal loss is imposed on these RMBS bonds:
1. An immediate 40% fall in house prices with no recovery ever
and
2. Prepayment to drop to 5%
and
3. Over 70% of homeowners would need to default cumulatively for the AAA tranche to be impacted - over 55% for the AA
Structural resilience
AAA European ABS structural resilience
Source:
M&G Investments, Bloomberg, Intex, 9 March 2021.
Note: Constant default rates (CDRs) are annualised figures
In this scenario, we have modelled an immediate UK house price fall of 40% with no recovery. This compares to the largest actual price decline on record of 18%. The UK Prime RMBS in the chart yields c.0.8%. For this security to lose the first £1/€1 invested, assuming prepayments drop to 5%, over 55% of homeowners would need to default to impact the AA tranche and over 70% to impact the AAA holders. The unprecedented levels of stress in this model compare to the UK’s peak historical repossession rate of 0.79% pa in 1992, a period of elevated unemployment and interest rates reaching 15%. In other words, we believe RMBS can offer a high level of protection against potential risks.
*This analysis is, in our view, representative of the UK Prime RMBS deals within the investable universe of our senior ABS strategies, based on our ongoing analyses of deals that come to market. We believe this analysis is supported by third-party research. In December 2020, FitchRatings performed a scenario analysis in its research paper, UK RMBS Stress Test: Ratings Resilient to Protracted Pandemic Forbearance, when the UK’s COVID-19 lockdown restrictions and mortgage payment holidays were still in place. No AAA or AA tranche defaulted in any of its modelled scenarios. In our view, the stress test shown above reflects more onerous conditions than those used in the FitchRatings analysis, as we have modelled no house price recovery, in contrast to FitchRatings’ assumed recovery periods of 24-60 months. Please note that modelled returns do not reflect actual trading and may not reflect the impact that material economic and market factors may have on decision-making and managing client funds.
Source:
Bloomberg, 31 March 2022. UK Prime RMBS transaction originally issued in August 2017.
Improving credit quality
Example UK Prime RMBS
August 2017
March 2021
Rating
Aa1/AA
AAA/AAA
Credit enhancement
12.0%
56.8%
Credit enhancement example: UK RMBS
Credit enhancement is the structural protection provided to investors, principally from the presence of bonds that are more junior in the capital structure
Increased credit enhancement and strong collateral performance can result in rating upgrades for mezzanine and junior bonds, as the credit quality of these bonds improves through their life
As borrowers in the mortgage pool repay, the transaction structure is deleveraged – this is because borrowers are regularly reducing the size of their outstanding mortgage principals, which decreases the LTVs on the property collateral and hence lowers default risks
As senior bondholders are repaid first, more of the remaining cashflows become available to mezzanine and junior bondholders over time
98% of rating changes for investment grade tranches of UK RMBS transactions over the last 5 years have been upgrades
*The % of credit enhancement broadly refers to the value of the RMBS transaction that must default before the tranche begins to incur losses. This typically includes the value of underlying collateral, as well as the cash reserve account, excess spread (loan repayments exceeding the amount due on RMBS bond coupons) and other structural transaction features.
"Historically, the credit quality of ABS has improved over time, as the underlying loan pool is deleveraged and senior bondholders are repaid."
Source:
M&G, ICE, Bloomberg, 30 June 2022. 1. (£) Sterling Overnight Index Average (SONIA), (€) EURIBOR, ($) Secured Overnight Financing Rate (SOFR), (¥) Tokyo Overnight Average Rate (TONAR) 2. Gross yield on £/€/$ Morgan Stanley Money Market Funds, ¥ JPY 3 Month Deposit 3. Yield to worst for the senior (A) tranches of all outstanding UK Prime RMBS transactions issued during the past five years, which are ineligible for ECB asset purchasing programmes and therefore, in our view, representative of yields available on these securities.
Yield premium
Yields on cash and liquid, defensive assets
Investment grade ABS have historically provided a consistent yield premium over equivalently rated government and corporate bonds, which we believe is maintained primarily by structural market forces that limit the number of potential buyers of these assets.
Past performance is not a guide to future performance.
"Nulla risus nulla, elementum in condimentum vitae, ullamcorper id erat. Aenean posuere, eros et gravida egestas."
£
Cash deposits (1)
1.19%
Money market funds (2)
1.11%
Floating rate European
AAA ABS (3)
2.55%
€
-0.20%
-0.52%
0.80%
$
1.50%
1.33%
3.17%
¥
-0.03%
-0.13%
1.05%
Source:
Bloomberg Pan European Floating ABS Bond Index TR Hedged GBP, ICE BofA – UK Gilts All Stocks Index (GAL0), US Treasury Index (G0Q0), German Government Index (G0D0), US Corporate Index (C0A0), Sterling Non-Gilt Index (UN00), Euro Corporate Index (ER00), 31 December 2021. All returns in local currencies.
Low duration
Floating rate AAA European ABS outperform investment grade bonds in 2021
The floating rate coupons paid by ABS can protect against interest rate rises, which are expected in major economies, including the eurozone, UK and US. This has led to recent outperformance from floating rate assets, such as investment grade ABS, compared to traditional government and corporate bonds, as the latter are vulnerable to capital losses from rising interest rates due to their duration risks.
Structural
resilience
Improving credit quality
Yield
premium
Low
duration
Structural
resilience
Improving credit quality
Yield
premium
Low
duration
Why invest in European ABS?
How do ABS work?
Who issues ABS?
2021 European distributed issuance Volume (€bn)
Capital structure
How are ABS created?
"Nulla risus nulla, elementum in condimentum vitae, ullamcorper id erat. Aenean posuere, eros et gravida egestas."
Asset-backed securities (ABS) are credit instruments (bonds) secured against a collective pool of underlying assets. These assets are usually loans of a similar type, such as mortgages or consumer and small business loans, which produce regular interest payments.
ABS therefore provide cashflows from loans that would be more difficult to trade individually, which offers investors new potential opportunities.
They have distinct protective features, including the way bond issues are structured, as well as the possibility to recoup losses via claims on specific collateral, such as a mortgaged property or a business’s assets.
ABS are created through a process called securitisation. The underlying assets are collectively pooled inside a bankruptcy-remote special purpose vehicle (SPV). A sponsor, such as a bank or mortgage lender, then creates new bonds, which are secured against the collective asset pool, and issues the bonds to investors. The bonds are split into ‘tranches’ that represent their seniority in the transaction’s capital structure, usually categorised as senior, mezzanine, junior and residual (equity) tranches.
Cashflows from the collective asset pool are distributed via a ‘waterfall’, which means bonds in senior tranches receive payments first. Once these payments to senior bondholders are fulfilled, investors in the tranche below receive their payments. Meanwhile, losses flow upwards, which means the most junior tranches incur losses first. Senior tranches only incur losses once junior tranches have defaulted.
The main issuers of ABS are financial institutions, notably banks, which use securitisation as a funding and de-risking tool. When these institutions lend to consumers and businesses, it may involve large amounts of money and take varying amounts of time to be repaid. By pooling the assets and selling them to investors, the institutions receive new money to lend to borrowers.
Source:
M&G, June 2022. For illustrative purposes only.
Source:
Source: M&G illustrative.
M&G, Deutsche Bank ABS outlook 2022. J.P.Morgan International ABS Spreadsheet (excluding CLOs) DB CLO Premier as of 31 December 2021, unable to define geographical location.
ABS
notes
created...
...and
tranched
ABS
notes
issued/sold...
…in
exchange for
investment
capital
True
sale of
assets
Cash received
(lender can now create more loans)
AAA
BBB
BBB
BB
B
EQUITY
AA
A
Pool of
assets
(Loans)
Investors
Special purpose
vehicle (SPV)
Floating rate coupons
Floating rate coupons
Structural resilience
Structural resilience
Spread premium
Spread premium
ABS coupons are often linked to prevailing cash rates, such as SONIA and EURIBOR, which means their potential income will increase if central banks raise interest rates.
This also effectively removes duration risks, which protects investors’ capital if bond yields rise.
Floating rate coupons
ABS provide multiple layers of credit protection. Robust deal structures, which include ‘credit enhancement’ through debt subordination; over-collateralisation; excess spreads; and strong underlying asset fundamentals all contribute to their resilience.
This is evidenced by low default rates in Europe. For instance, European residential mortgage-backed securities (RMBS) have an average long-term default rate of just 0.3%pa across all credit ratings, which includes investment grade and high yield debt.
Structural resilience
Source: S&P Global, 13 May 2021. Data range: 1983-2020.
ABS have historically provided a consistent spread premium over equivalently rated corporate bonds, which can help to reduce the effects of inflation on incomes.
We believe this premium is mainly caused by structural market dynamics, which reduce the number of eligible investors in the asset class.
Spread premium
Returns on the assets repay the low-risk bonds first
Income and capital then flow down
Any capital losses flow up; riskiest bonds bear losses first
AAA
AA
A
BBB
BB
B
Equity
A guide to European asset-backed securities
Higher inflation, rising interest rates and geopolitical risks are leading many investors to diversify their fixed income portfolios away from traditional government and corporate bonds.
We believe European structured credit, also known as asset-backed securities (ABS), could be a potential solution to help investors navigate a more uncertain investment environment.
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
SUBSCRIBE
ABS
explained
ABS
explained
Investment grade
Investment
grade
High
yield
High
yield
ESG
ESG
2020
ESG in ABS framework established
Relevant and material ESG factors identified across major ABS sectors
2021
ESG in ABS scorecard under development
Designed to score material ESG factors and map to M&G’s scorecards for corporates and sovereigns
2013
M&G signs up to UNPRI
ESG formalised as part of our ABS credit research
2019
ESG dashboards
Evidence: ESG #themes in Research allows ESG interactions to be monitored across all credit research
2008
Avoid poor underwriting in the run up to the global financial crisis
Our identification of poor lending standards in areas such as US residential mortgages and European property lending enabled us to largely avoid credit issues during the GFC
Early 2000s
Development of ABS credit research team
Governance and transaction factors always considered in deal analysis
Q2/2021
M&G contributed to UNPRI’s first ever paper on ESG integration within securitisations
2022 and beyond
Refinement of scorecard/
emissions data
Q1/2021
Emissions modelling
ESG formalised as part of our ABS credit research