More structured finance investors are honing their gaze on esoteric asset classes as they look to diversify their portfolios away from the more traditional consumer-facing ABS asset classes. This is important given concerns over the health of the US consumer base, but issuers must become more frequent and secondary markets need greater liquidity for the growth of the market to accelerate.
Away from mortgages, auto ABS has for years taken the largest share of public ABS issuance. Credit cards are also a significant part of the asset class, although they are not as prominent as they once were. This means investors in asset-backed securities are heavily exposed to US consumers, who are being intensely pressured by persistent inflation.
As a result, market participants say that appetite for esoteric ABS — which includes assets such as equipment, aviation, data centres and music royalties — has been increasing.
The chance to diversify away from consumer credit combined with the opportunity to buy paper with a variety of weighted average lives (WALs) means that esoteric ABS is becoming attractive for investors, said Priya Desai, head of ABS investments at MetLife, during a panel at IMN and FINN’s ABS East conference in Miami.
“The diversification of weighted average life [in the bonds] is super valuable to us, given that [as an] insurance company, we can invest across the WAL profiles,” Desai said. She added that, while most consumer ABS bonds offer WALs of up to three years, those in esoteric deals often go up to five or seven years.
Esoteria's attraction grows
These advantages also become more pronounced as the interest rate cycle is likely nearing its peak. Investors are keen to lock in high interest rates, and esoteric ABS paper allows them to do this for a longer duration. US rates have been increasing rapidly down the maturity curve since September.
The growing interest in esoteric ABS is also a result of the commercial assets, such as equipment, that often back these deals. The financial health of US consumers has been in particular focus over the past two years as inflation remains stubbornly high and the US Federal Reserve has had to increase rates in an attempt to slow economic activity.
Auto ABS issuance, with almost $120bn of issuance, accounts for over 51% of all public ABS primary volumes year-to-date. However, increasing delinquencies and losses continue to trouble investors.
Non-prime auto loan losses climbed to 9% in September, up 82bp month-on-month, and 19bp higher than this time last year, according to KBRA’s auto loan indices. Delinquencies exceeding 30 days were at 14.4%. Several ratings analysts told GlobalCapital in Miami that consumer ABS performance across the board is expected to continue to deteriorate.
Another reason that esoteric ABS is finding favour is that RMBS and CMBS volumes have also been significantly down in 2023.
Excluding consumer and marketplace loan deals, which are often grouped in with esoterics, year-to-date ABS issuance from esoteric sectors is $56.5bn from 117 deals, according to data from Finsight. This means it is likely to be a challenge to reach last year’s primary volume of $72.5bn from across 130 transactions, and it is lower than the $85.3bn issued in 2021 — a bumper year for all capital markets issuance.
However, this is a relatively resilient performance given the challenges in capital markets. And it shows significant growth than in pre-pandemic years. Esoteric ABS issuance minus consumer and marketplace loans was $52.3bn in 2019 and $48.2bn in 2020.
Moreover, public issuance figures do not tell the full picture as many deals in esoteric sectors are executed privately, and to a far greater extent than in more on-the-run asset classes.
Broadening the appeal
Historically, esoteric ABS investors have been insurance companies or other buy and hold investors. However, the yield and spread opportunities the asset class offers are beginning to lure more alternative asset managers.
In the secondary market, the investment grade part of the capital stack is dominated by insurance companies, but money managers and hedge funds are more prominent down the capital stack, said Matt Henderson, head of ABS trading at Santander, during the esoteric ABS panel in Miami.
“Financing, in terms of repo [repurchase agreements] has gotten more compelling and interesting as banks have looked to grow that part of their business,” said Henderson. “I think that’s allowed hedge funds who have traditionally played in certain parts of the cap stack, both in consumer and esoteric ABS, to be able to do that and hit levered returns that they would not have been able to hit a couple of years ago.”
In order to grow the investor base, esoteric ABS issuers had to convince the market that their respective sectors could grow their presence in the ABS market.
Many money managers hesitate to spend time on deals from issuers or asset classes that will not see regular issuance.
“If you want investors to spend time on an asset class, you have to give them some level of comfort that there are going to be additional assets or additional investment opportunities,” said Yezdan Badrakhan, MUFG’s head of esoteric ABS Yezdan Badrakhan during the panel. “That fundamentally is what I think helps grow asset classes and improve their spreads, and gets everyone comfortable with assets.”
Certain esoteric asset classes including data centres, fibre and solar have already been growing consistently over the years in terms of primary volume.
Year-to-date solar ABS issuance is at $4bn, on track to catch up to 2022’s $4.3bn issuance volume, which was the busiest ever year for the sector. Cell tower, data centre and billboard ABS total primary issuance to date is at $10.7bn, with at least one more deal on the way. Last year there was $4.4bn of new issue volume from those sectors, and this year has the potential to become the best-ever year for the sector, if it can surpass the $12bn issued amid 2021’s far more benign market conditions.
“The transaction volumes aren’t by accident,” Badrakhan said. “It’s a fundamental need that is ever-increasing.”
Need for liquidity
With the expanding buyer base, however, comes an increasing need for secondary market liquidity.
Given the greater number of participants in the market, issuers are asking their arranging banks if they can support their deals in the secondary market, Badrakhan said during the panel.
Issuers are also trying to become more consistent with their presence in the market as they look to shrink the spread between themselves and their competitors, according to Henderson.
“A large part of that is your ability to [offer] access [to] the secondary markets,” he said.
Not having secondary liquidity impacts the ability to syndicate a deal across a broad group of investors while widening the spread between competitors or other asset classes, according to Henderson.
Even when there is demand for esoteric ABS paper in the secondary market, it can be challenging for investors to get their hands on the bonds they are looking for.
One trader told GlobalCapital that one of their clients was looking to buy whole business ABS paper from a certain deal, but it was challenging to get a hold of the bonds since most initial investors were planning to hold them until maturity.
The investor ended up paying a premium of around 15bp to acquire the bonds, the trader said.
In addition to liquidity and programmatic issuance, investors would also like esoteric issuers to have some “skin in the game”, according to Desai. This could be in the form of holding residuals or the ‘E’ notes for aircraft possessions, she said.
“We do understand that these issuers are looking for leverage, they’re looking to grow this business, but at the same time, do you have skin in the business?” she said.