Global Perspectives: ABS may provide attractive opportunities beyond traditional fixed income

Lara Castleton: Hello, and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share insights from our investment professionals and the implications they have for investors. I’m your host for the day, Laura Castleton, and today we’re focusing on asset-backed securities, or ABS.

The ABS market is one of the more established asset classes in fixed income, yet is often underrepresented in traditional benchmarks, and as a result, under-discussed. That disconnect has become more important as investors are looking beyond traditional benchmarks to understand where risk and resilience really sit. As investors navigate higher rates and reassess the strength of the consumer, this asset class has come into sharper focus, both for its fundamentals and its role within portfolios.

To help us walk through the ABS landscape, I’m thrilled to be joined by two of Janus Henderson’s most experienced securitized investors, Nick Childs, Head of Securitized and Quantitative Fixed Income, and John Kerschner, Global Head of Securitized Products. Gentlemen, thank you both for being here. Thank you.

John Kerschner: Thanks for having us.

Castleton: All right, so let’s kick it off with you, John. Just give us the lay of the land of the ABS market in general.

Kerschner: So a lot of people ask, when did ABS actually begin? And I think people would be surprised to know it actually started during the Civil War when the Confederacy issued bonds backed by cotton that were sold in Europe at 7% interest. Treasuries [were] about 5.5% back then, so about 150 off. Seems kind of tight to me, quite frankly, for that kind of risk.

But modern ABS, which is probably what most people want to discuss, started back with Sperry computer leases in 1985. I’m old enough to remember a Sperry computer. And so, it was actually equipment, not auto or credit cards, although an auto securitization, auto ABS securitization from GM [General Motors] came the next year, and then credit cards started in 1987. So really, mid-80s. It’s grown a lot since then. But interestingly enough, the ABS market since the GFC [Global Financial Crisis] has been relatively stable, about $800 to $900 billion, whereas other sectors of securitized products like mortgages have basically doubled, from about $4.5 trillion to $9 trillion. CLOs have quadrupled from about $300 billion to $1.2 trillion. CMBS also about doubled, from about $900 billion to $1.8 trillion. So, ABS, pretty static. A lot of that has to do with the fact that credit card usage actually went down a lot post-GFC, but now, again, is growing somewhat. But, so, fairly stable.

One interesting thing, though, that a lot of people don’t realize, is if you look at the biggest fixed income index, the Aggregate index, it’s mostly U.S. Treasuries, about 50%, mortgages 24%, corporate credit about 23%. Securitized is less – besides agency mortgages – is less than 2%, and ABS is only about 40 basis points. So if you’re investing in a core, core plus strategy that benchmarks to the egg, you’re probably not getting much exposure to ABS.

Castleton: Okay, and so ABS, you already mentioned a couple, but just what’s the underlying baskets again, just as a reminder?

Kerschner: So there’s the big ones are auto, credit cards, and student loans. And then there’s all sorts of other things like equipment and timeshare and what we basically [call] fast food, often called whole business securitizations, but that’s just fast-food franchise fees, containers, rail cards. And obviously a big one these days is data centers. So there’s all sorts of smaller, a little bit more esoteric asset classes within that ABS umbrella. Any kind of company that has a very stable recurring cash flow, they will try to securitize it. And that’s where the active management comes in from Janus Henderson.

Castleton: Okay, so then Nick, Kersch mentioned just the evolution of ABS has not changed too much in size, at least, especially post-GFC, but maybe can you talk through how the market has evolved over time?

Nick Childs: Sure, yeah. Pre-2008, you know, issuance was kind of dominated by looser underwriting standards, lower amounts of credit enhancements … rating agencies [were] probably not all that informed or a bit overly optimistic, right? And more generally, I think the space was just overly levered, right? Post-financial crisis, 2010, we saw Dodd-Frank, the Dodd-Frank Act. Most importantly, there was the risk retention function. So now issuers have to have skin in the game when they issue these securitizations. Equally, rating agencies saw substantial scrutiny. So their requirements around credit enhancement increased dramatically. And just generally, the market underwriting has improved dramatically. And so, if you look at the market today, pre-2008, losses were nearly double that of post-2010, right? And so that really does show you the structure is much better in the marketplace, equally, the collateral or underlying loans are better underwritten.

Kerschner: One interesting fact of that is that in ABS securitization, there has not been a default since the GFC in IG [investment-grade] rated ABS. So, it shows you that this wasn’t just for show, these new skin in the game, like Nick mentioned, and the underwriting and just the way they structure these deals, it’s actually working as advertised. And we’ve gone through some really tough times since the GFC, if you think of COVID and Liberation Day and what happened in 2015-‘16. So these structures are holding up.

Castleton: I think that resilience may surprise many, because they definitely focus on the headlines and associate the rising delinquencies with the ABS market.

So John, where do you see the market today in terms of the state of the consumer? And then how does that trickle through then to the ABS market?

Kerschner: Yeah, it seems every time I come in in the morning and turn on my computer, there’s a news story about how delinquencies are at all-time highs, mostly focusing on the auto sector. This is true, but a couple of explanations around that. First of all, it’s not an apples to apples comparison, because the auto ABS sector is constantly changing, meaning new issuers, more down in credit issuers. And if you think about it, if you’re a new issuer, where are you going to try to compete? The high-end credit quality is very well dominated by the big captive finance companies, even the middle of the stack by the really well-respected issuers that focus on that. So, it’s more on the bottom end, the lower-credit rated borrowers that they focus on. So as the market grows, you get more and more of these lower credit ratings, and so delinquencies go up.

Another thing is, this time of year, delinquencies tend to go up as people spend more for the holidays and they fall behind on their other bills. But subsequently, people tend to get their tax refunds and then pay off their debt. So normally in the subprime auto space, delinquencies go down by about 120 basis points from January to April. And in the prime space, it’s about 10 to 12 basis points. So we should see some improvement, particularly this year, because tax refunds are forecasted to be quite a bit higher, about $1,000 on average higher. So average tax refund is about $3,000. That is expected to go up to $4,000. Most people use that to pay down debt.

Castleton: So safe to say then that there maybe is a little bit more stress on the consumer in some of these areas. You call it still overall top-line healthy consumer. And then I guess the question is, how does that impact ABS market itself?

Kerschner: Yeah, well, I don’t believe this gloom and doom that you’re hearing in the press all the time. We had a very robust job number. Unemployment is down. Unemployment rate is now down 25 bps from the peak. So hopefully moving in the right direction. Need a couple more months of data. I look at it as somewhat of a Goldilocks economy, right? Like now, unemployment’s coming down, initial jobless claims are kind of near all-time lows. If you go back pre-GFC, 2004 to 2006, initial jobless claims were like low 300,000s. Now they’re low 200,000s. If we had a week where initial jobless claims went up to 300,000, the bond market would sell off materially. So the job market, yes, it’s a low-fire, low-hire type market, but I don’t think it is bad as a lot of people make it out to be. I think the COVID years were the anomaly, right? Where it was just … there were all these jobs and people were changing jobs. And now we’re kind of back into a new normal. And if anything, I think it’s actually relatively strong job market. If you look at 4.3% unemployment rate, only about 29% of the time has it since 1990 has been at that rate or lower. So in a long history, it actually looks pretty good.

And [GDP] growth, we had 3.8% growth [in the] second quarter of last year, 4.4% growth in the third quarter. We haven’t gotten fourth quarter [data] yet because of the government shutdown, but we expect it to be north of 3%. Given the stimulus in Q1, we think it’s going to still be strong. So inflation coming down, growth being pretty strong … yes, the job numbers aren’t ideal, but they’re not as bad as the market seems to think they are. And so overall, I think that the consumer isn’t as bad as many people think. It’s just, it’s coming off of COVID where everybody got stimulus and it, like all numbers as far as delinquencies and bankruptcies and things like that, all measures of consumer credit went to all-time good levels, and we’re now normalizing.

Castleton: Nick, then do you need the consumer to really hold up, or in the ABS structure, has there been actually the ability to see upgrades or the way you structure a deal can actually help you be more resilient if the consumer does start to show increased delinquency?

Childs: Sure, I mean, much of the structure is investment grade, right? And I think investment grade today means investment grade. I know it didn’t a little bit during the Global Financial Crisis. You know, I think what others don’t understand too is, look, you know, there’s different parts of the capital stack, right? I would say the market more generally is high quality, much more so in rating than it was in previous years. And then around the borrower, look, we know these things. These things aren’t surprises to us, these articles in the Wall Street Journal, et cetera. So that underwriting follows that. Like our models change, and in real time, rating agency requirements change, our underwriting changes. So much of the concern tends to be always kind of in your rear view mirror, if you know what I mean.

Castleton: Okay, so if we feel broadly optimistic on the consumer, and even if there are rising delinquencies, we clearly have the ability to adapt real time, as we always do, to look past the noise. Are you seeing relative value in the ABS sector then over other areas of the fixed income market, and why in particular?

Childs: Yeah, I think one of the biggest issues with fixed income markets is we just extended so much in interest rate risk, and investors saw that in 2022. And what’s great about the consumer borrower, an auto loan or whatever style of consumer loan, most of these underlying assets are actually very short in duration. So you’re getting a pick, or you’re getting increased spread or increased yield over corporate credit and you’re not taking that duration risk in your portfolio. And I think that makes a lot of sense.

Castleton: Okay, so looking across the entire sectors, you can get pretty resilient yields in the market today without the interest rate volatility that you may get from longer duration, say, investment-grade corporate credit.

Childs: I think that’s well said.

Castleton: Okay, so John, then if we look at the fundamental story behind the ABS market, which you mentioned all of the things that could be underneath the hood, there are plenty of them. What are a couple of the fundamental ideas we really like, or maybe some we might be more cautious on?

Kerschner: We have been cautious for over a year now on sub-prime credit cards. This was before the infamous 10% cap on credit card interest rate, obviously subprime credit card business model does not work at a 10% cap. A lot of these issuers charge 20, 25, 30%. But one point on that 10% cap, it’s only for a year, it’s very unlikely to get passed, but this is the administration trying to come up with creative ways to increase affordability, right? That is the buzzword of the day. So anyway, we’re not big players in credit cards to begin with, and particularly subprime cards, but that even increased our desire to stay away from that sector. And then student loans, just because of regulatory risk.

Now, places we do like, prime auto, particularly credit risk transfers, which allow us to go down the capital stack and use our underwriting to really pick the deals that we like. You’re getting really nice spreads. And again, like Nick said, they’re pretty short-weighted average life. Cell tower [ABS] … you know, look, I use my phone as much as anybody. I don’t think that’s going away. And the interesting thing with cell tower ABS is, every generation, you know, you go from 2G, 3G, 4G, 5G, it requires more equipment on the towers and they have less ability to broadcast their signals. So you need more towers, and there are rate increases that are built into it. So it’s just a very resilient part of the ABS market that I don’t think a lot of people appreciate, but very stable cash flows. And they actually, depending on the issuer, trade at relatively attractive spreads.

Marketplace lending, which is just another fancy way of saying unsecured consumer lending, but from very special lenders, the top-tier lenders, again, you’re getting higher spreads and lower weighted average lives or shorter durations. I’ll mention data centers. Look, it’s been a very hot topic. Very quickly, the issuance in securitized, both ABS and CMBS, won’t be nearly as large as what we’re seeing in corporate credit. You know, people are talking about several $100 billion a year in corporate credit. I think, you know, reasonable people can disagree on what that number is, but it’s going to be a huge number. And securitized, combining both ABS and CMBS, it’s probably like $25 or $30 billion a year. So very digestible for a $5 trillion, without agency MBS, securitized market. And very wide spreads. You’re getting, for investment grade, triple Bs, 300 off. A prime auto, triple B, would be about 125 today. Subprime, 150. So, kind of getting double the spreads you’re getting in some of the other asset classes with the same rating. Again, you got to know what you’re doing. The structures are very important. The technology behind the data center, where it’s located, can be very important. Obviously, who the tenants are. But we have the team to do that underwriting. So we’re very selectively taking advantage of that asset class.

Castleton: As you look forward to the rest of the year, what would be the closing thoughts that you might want to leave the audience with in terms of gaining access to the space, the importance of it and the role it can have in portfolios?

Kerschner: I mean, I’ll just start in saying, look, you’re getting a higher credit quality type asset versus, you know, most of corporate credit. And you’re getting very attractive spreads for that. So, on a risk-adjusted basis, that’s very attractive. If you have just a generic core plus portfolio, oftentimes there’s very little ABS in there because there’s very little, 40 basis points, in the benchmark. So that is something to consider. ABS is giving you diversification, high credit quality, relatively high spreads. All those things lead to an optimal portfolio. And I think a lot of investors, particularly given the size of this market, are underinvested in this asset class. And again, I think a lot of people think of ABS, oh, it’s boring, Prime Auto, you know, GM, student loans, credit cards. Hopefully we opened up the box a little bit to show you there are a lot of ways to add alpha to the portfolios in this asset class. And that’s what we’re spending every day doing for our clients at Janus Henderson.

Castleton: Thank you both and completely agree. My team works with clients talking about fixed income, they are looking to diversify beyond traditional benchmarks. So the ABS market clearly outlines a lot of opportunities for not only risk-adjusted yield, but fundamental diversification opportunities. So appreciate you walking us through this market.

And thank you for listening. We hope you enjoyed the conversation. For more insights from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts, or check out our website at janushenderson.com. I’m Laura Castleton. Thank you. See you next time.