One of the problems with credit markets is classification conventions. If you look at the sterling credit index methodologies, you will see a lack of consistency between providers on bond and sector categorizations. Asset Backed Securities (ABS) perfectly reflect this.
At RLAM, we make extensive use of covered bonds to improve returns or reduce risk in client portfolios. However, not all of these bonds will qualify as asset-backed securities. The industry – asset managers, banks and index providers – felt that ABS only covered a subset of covered bonds. Our diversified fund of asset-backed securities helps illustrate the main points of difference between our approach and the narrower designation.
There are two main ways to gain exposure to bonds with enhanced collateral: securitizations and corporate collateralized bonds. Most ABS funds focus on the former. In securitizations, debt is raised against a specific pool of assets held within a special purpose vehicle (SPV). Examples include auto loans, residential mortgages, student loans, and credit card loans and are typically focused on consumer-related industries. Tranches are issued which reflect the priority of the receivable over the cash flows and the underlying assets; there is no recourse to the sponsor if things go wrong. Most securitizations are issued in the form of floating rate notes, referenced at a floating market interest rate, for example, Sterling Overnight Interbank Average (SONIA).
Corporate covered bonds are fundamentally different, although they clearly fall within the definition of being asset-backed. Covered bonds are issued by companies that provide assets as collateral. Typically, these bonds are fixed coupon, with maturities of five years and more. Covenants are usually in place so that if the value of the collateral falls below a threshold (x1.5 or x1.6 the value of outstanding bonds), the issuer is required to pledge more collateral. .
In our diversified asset-backed securities fund, we provide our clients with exposure to both securitization and secured corporate debt, with an emphasis on being a senior lender. We have a rich heritage in both fields, having invested in the earliest residential mortgage-backed securities in sterling (from Lloyds and Santander) and the earliest covered bonds in sterling (issued by Leeds Building Society, secured by mortgages first-rate) after the global financial crisis. . After the crisis, banks had to offload assets through securitizations – we were in a good position to examine these structures given our extensive experience in investing in covered corporate bonds.
Our approach dramatically expands the asset-backed universe, integrating housing associations, covered bonds, investment trusts and infrastructure issuers. To further enhance diversification, we may also hold unsecured corporate debt up to a maximum of 20%.
We thus avoid the pitfalls of over-concentration on certain sectors such as credit cards, residential mortgage loans and car loans. One challenge is managing duration, as secured corporate debt is typically longer. To remedy this, and to align with our benchmark (SONIA), we use a range of simple derivative instruments to hedge interest rate risk. We are left with a corporate bond fund, heavily biased towards asset-backed bonds in the broadest sense, with little or no interest rate risk. This allows us to choose the best of both worlds: covered corporate bonds and securitizations.
The main risks to which our clients are exposed are the widening of credit spreads and default; the latter is significantly mitigated by our focus on senior secured debt, which maximizes recovery in a deteriorating credit environment. On a daily basis, the fund will reflect movements in credit spreads and volatility will reflect the maturity profile of the credit bonds held. However, downside protection is greater, compared to securitization-oriented strategies, due to the greater diversification and quality of our credit position. From a liquidity perspective, our focus on senior debt tranches means that we largely avoid exposure to junior securitization tranches – the area that can become most illiquid in times of stress.
Going down the hierarchy of ratings in securitizations is not in itself bad. Clearly the returns are higher, but it is important to know what risks are being taken. The average rating of second salary (slightly junior) securitizations is generally high at AA, reflecting the methodologies of rating agencies. However, this can give false comfort, as AA-rated securitizations historically have cumulative depreciation / default losses that are significantly worse than AAA-rated securitizations and AA-rated corporate bonds. This reflects the cliff edge risk introduced by tranche structures – in our opinion, credit ratings don’t tell you everything.
There is another benefit to our approach: buyouts. Many covered corporate bonds have clauses that allow the issuer to redeem bonds, but only at government bond yields (i.e. no credit spread) or low yield premiums. . Why would a transmitter want to do this? It could be that the interest cost is too high, the debt is no longer needed, or the issuer wants to do something with the encumbered assets. Whatever the reason, such buybacks can be a pleasant surprise – not something you usually get in the bond markets!
Compared to AA (unsecured) companies, the default / depreciation statistics in the graph show a significant improvement in the risk of loss for AA unsecured companies compared to junior AA rated securitizations. Our approach allows us to select the best unsecured bonds (for a small proportion of the fund), while maximizing the benefits of covered bonds, namely: the undervaluation of seniority and the best available recovery; the diversity of opportunities (by maturity, cash flow and economic exposure); and the higher spread available due to rating methodology, complexity and regulation. Unsecured bonds are often targeted towards areas of diversification and improving yields, such as financial debt and highly regulated utilities.
A differentiated fund offer
The Diversified Asset Backed Securities fund is part of our sterling credit portfolio, with most bonds denominated in sterling. A key attraction is that our obligations are generally governed by English law, an important advantage as other jurisdictions tend to have weaker protections for covered bond holders. For investors in pension plans, there is unlikely to be any consistency in what constitutes an asset-backed obligation.
Within the Royal London Diversified Asset Backed Securities Fund, we have made it clear that our horizons are broad and we believe this has served our clients well in the long term. Whether used as a cash-plus generator for Liability-Based Investment (LDI) portfolios or as a diversifier against generic corporate bonds, we believe the Diversified Asset Backed Securities Fund is a differentiated offering on the pound sterling market.
Shalin shah is a senior fund manager at RLAM
The value of investments and the income from them may go down as well as up and are not guaranteed. Investors may not get back the amount invested.
Find out more about RLAM’s bond solutions on rlam.co.uk/fixed income
For business customers only, not suitable for home customers.
This is a financial promotion and not investment advice. The opinions expressed are those of the author on the date of publication, unless otherwise indicated, which are subject to change.
The Fund is a compartment of Royal London Bond Funds ICVC, an investment company with variable capital with separate liability between the compartments, incorporated in England and Wales under registration number IC000797. The Company is a UCITS with multiple compartments. The Authorized Company Administrator (ACD) is Royal London Unit Trust Managers Limited, authorized and regulated by the Financial Conduct Authority, with reference number 144037.
For more information on the fund or on investment risks, please refer to the Prospectus or the Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam. co.uk.
Issued September 2021 by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL. Authorized and regulated by the Financial Conduct Authority, Company Reference Number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited.