Accessing the investment opportunity
The relative value case has strengthened
Residential mortgages spreads have become more compelling, in our view, since the onset of the COVID-19 crisis as the margins on mortgages have widened versus swaps at the same time as yields on public corporate bonds have tightened. Mortgage rates have come down slightly but far less than swap rates, which have been largely driven down by unprecedented central bank activity, in the form of lower-for-longer rates and the ramping of asset purchases under QE since the pandemic.
Exploring the drivers of investment return
The emergence of a specialty finance sector in Europe in recent years has opened up an opportunity for investors to gain exposure to a large, mature and resilient asset class – consumer finance – offering myriad of potential portfolio benefits, including higher risk-adjusted returns and diversification of risk.
Assessing risk and return
”
“
illo inventore veritatis et quasi architecto beatae vitae.
Find out more about our private debt capabilities
For investors looking to make a strategic allocation to the asset class, there are differentiated ways in which asset managers with the right skills and capabilities can offer access to consumer finance assets and capture different risk/reward profiles to help investors meet their needs and objectives.
The specialty finance approach acquires economic exposures in performing residential mortgage and consumer loan pools to build diversified investment portfolios and targets higher risk-adjusted returns potentially available from the asset class. Specifically, the returns on these assets are enhanced through the use of efficient, cost-effective securitisation and term financing technology. An investment approach that directly invests in pools of performing residential mortgages and consumer whole loans to generate attractive cashflows from the assets, could also be very interesting for a number of investors, including prudently-regulated institutional investors such as insurers.
The market opportunity
Consumer finance is a substantial and diversified asset class which is comprised of loans and credit provided directly to consumers, rather than to businesses and companies. These loans are typically grouped into two main categories: residential mortgages (owner-occupied and buy-to-let) and consumer loans (including unsecured personal loans, auto loans, student loans and credit card receivables).
The majority of asset owners have limited direct exposure to consumer risk in their portfolios and the predominant way many have historically gained access to consumer finance assets has been through parts of the asset-backed securities (ABS) market, typically in the form of residential mortgage-backed securities (RMBS), and other consumer loan-backed securitisations.
Only a few years ago, the opportunity was largely inaccessible to institutional investors. However, regulatory capital constraints placed on retail banks has left them with little choice but to find efficient ways in which to free-up capital on their balance sheets, to do more lending, and meet higher capital and leverage ratios imposed by the regulators. One avenue has been for banks to embark on whole loan asset sales, including residential mortgages and other consumer loan types, to trusted, non-bank partners.
The market opportunity is sizeable and scalable, with an estimated €27 trillion of consumer loan balances globally.
Why make an allocation to the asset class?
We believe there are a number of advantages for investors looking to make a strategic allocation to the asset class. For one, there is strong portfolio diversification potential away from traditional asset class exposures as investors are typically under-allocated to consumer risk, especially direct investments in residential mortgages and other consumer loans.
Diversification of risk
Investment in the asset class is usually via a fund structure offered by an asset manager that acquires multiple residential mortgage and consumer loan portfolios on behalf of investors, rather than gaining exposure on a transaction-by-transaction or loan-by-loan basis. Accessing the opportunity in this way could offer investors the potential for diversified exposure to the asset class, through investments made in multiple, granular pools of residential mortgage and consumer loan pools across geographies to enhance sponsor/originator, country and asset type diversification.
Investing via a fund structure with an asset manager also provides origination capabilities, analytical expertise and benefits of scale.
Acquiring residential mortgage and consumer loan assets requires extensive commercial and legal due diligence on the part of the buyer, which means that sellers of the books limit the number of suitable partners able to participate in such transactions.
Historically resilient risk-adjusted returns
There are a number of different drivers of risk and return in the asset class. Because these are whole loan portfolio purchases (rather than debt secured against the assets) the returns are driven by the interest payments on the loans. Therefore, the main risk associated with these investments is higher-than-expected defaults feeding through to the underlying asset pools. Consumer debt has exhibited good through-cycle credit characteristics despite macroeconomic headwinds, and the underlying loans have exhibited relatively low default and loss rates historically, therefore delivering stable, attractive, investment returns.
Historically robust through-the-cycle credit characteristics
Looking at the historical performance data, consumer finance assets have shown relative resilience even through major downturns, which we believe is due to supportive factors at both a macro level and a micro level. Over the years, European regulators have made residential mortgages and other consumer loans progressively safer and stronger by imposing restrictions on bank lenders regarding borrower due diligence and loan suitability, effectively attempting to prevent consumers from borrowing at unsustainable levels. In Europe, in particular, banks dominate the consumer lending landscape and they are subject to consistent regulatory scrutiny on their credit underwriting standards and lending criteria, setting the tone for the entire market.
The rigorous lending practices employed by lenders across Europe go some way to explain the low level of defaults and historical loss experience of the asset class, and particularly residential mortgage markets, with loss rates averaging an equivalent corporate loss rate of between AA and A-rated corporates over the same period – while offering significantly higher returns.
Underlying loan assets exhibit attractive returns
The absolute return levels of residential mortgages and consumer loans has remained attractive. Being bank loans in nature, residential mortgage and consumer loan spreads are not driven by financial market dynamics, helping to insulate spreads from the day-to-day fluctuations in financial markets. The spreads on these assets are determined by relative supply and demand for mortgages or other consumer loans and credit, and so are more of a function of bank deposit funding levels and the level of competition between loan and credit providers in the market. Therefore, markets where there are few lenders operating and vying for market share, can offer particularly attractive spreads for these portfolios.
Historically, European residential mortgage loan margins have held up even as corporate bond yields have fallen, and have also demonstrated greater stability relative to their corporate equivalents. The following two charts show the spread-to-swap returns of prime UK and Dutch mortgages versus equivalent corporates, respectively.
In summary, we believe that investors have a unique opportunity to gain access to a large, mature and resilient asset class amid ongoing structural changes in the banking sector which are providing opportunities for alternative providers of capital to position as asset acquirers of performing whole loan portfolios, including residential mortgages and consumer loans. Moreover, we believe the investment opportunity is particularly compelling due to a unique confluence of factors – and in view of the supportive macro-economic, regulatory and political backdrop, which we think bodes well for the sustained credit performance of the consumer – therefore providing a potentially interesting entry point for investors.
There are differentiated ways in which asset managers can offer access to consumer finance assets such as residential mortgages and consumer loans, and capture different risk/reward profiles that can help a range of investors meet their needs and objectives. If investors can invest in securitisations without facing punitive capital treatment, then the ability to access efficient, cost-effective and non-recourse financing, means that the specialty finance approach could allow investors to potentially benefit from higher risk-adjusted returns.
The speciality finance approach – utilising cost-effective financing to drive higher risk-adjusted returns
As well as benefiting from good asset value and default characteristics from the underlying loans in a pool, acquirers of these loan pools can source non-recourse, term senior financing either through the ABS markets or term financing to match the duration of the loan pool, as a means to enhance the risk-adjusted returns potentially available from the asset class. Securitisation technology is tried and tested to efficiently tranche portfolios of residential mortgage and consumer loans to achieve different risk/reward profiles, much like leveraged loans are packaged into collateralised loan obligations (CLOs), with the acquirers of these loan pools retaining the residual equity tranche in the structure.
Reflective of the robust historical default data, the cost of such financing for consumer loans and residential mortgages is among the lowest of securitised asset classes – considerably lower than corporate ABS, such as CLOs and commercial mortgage-backed securities (CMBS). The attractive financing costs are a positive side-effect of the spread compression seen elsewhere in financial markets, ABS markets have tightened considerably as a consequence of central bank asset purchases and investor appetite for floating-rate product boosting the returns available to owners of these portfolios.
An approach focused on cashflow generation
Alternatively, if investors are focused on generating attractive cashflows to meet their needs and objectives and are not targeting higher return hurdles, then an investment approach that directly acquires pools of performing residential mortgages and consumer whole loans to earn income-driven returns with low levels of duration relative to equivalent-rated corporate credit, could offer another interesting avenue in which investors can gain access to the asset class.
There is strong portfolio diversification potential away from traditional asset class exposures as investors are typically under-allocated to consumer risk, especially direct investments in residential mortgages and other consumer loans.
“
European regulators have made residential mortgages and other consumer loans progressively safer and stronger by imposing restrictions on bank lenders regarding borrower due diligence and loan suitability, effectively attempting to prevent consumers from borrowing at unsustainable levels.
”
“
Residential mortgages spreads have become more compelling since the onset of the COVID-19 crisis as the margins on mortgages have widened versus swaps at the same time as yields on public corporate bonds have tightened.
”
“
There are differentiated ways in which asset managers can offer access to consumer finance assets such as residential mortgages and consumer loans, and capture different risk/reward profiles that can help a range of investors meet their needs and objectives.
”
Extensive, granular, loan-by-loan, historical data from the originator is made available to the buyers of these loan portfolios. When combined with historical data from third-party originators and the European Data Warehouse this can facilitate the manager's underwriting, stress-testing and portfolio selection and pricing. The outputs are used in negotiations to determine which portions of portfolios to include and exclude and the appropriate price to pay.
The absolute quantum of data required to perform this analysis is beyond the capacity of off the shelf spreadsheet and database programmes and proprietary Python based systems must be built.
To stress test a recent purchase of auto loans, over five billion data points sourced from historical ABS transactions and the seller's loan book were analysed. We used this to generate likely loan default probability and loss risks over the lifetime of the loans, which enabled us to determine the appropriate purchase price to assume these risks and generate the desired level of return.
“
”
“
”
“
”
Other consumer loan types, including UK unsecured personal loans, have a comparable value proposition to high yield bonds to reflect the additional risk since they are unsecured. They typically offer higher loan margins and have historically provided a higher return, even after taking losses into account and contingent on the purchase price of the pool. In the example of German auto loans, these loans have historically exhibited higher returns over equivalent quality corporate credit, while their loss experience has compared favourably to BB loss rates.
