The asset-backed securities (ABS) market helps investors gain exposure to real-economy assets offering a range of risk profiles that have the potential to produce relatively high stable yields. ABS assets also have the potential to offer investors some degree of capital protection due to their collateralized nature.

Valued at $4.4 trillion, the ABS universe is large enough to give investors geographic and sector diversity. The heterogeneous nature of the market allows investors to tailor their preferred risk/return profiles to match a range of investment objectives and time horizons.

The main benefits traditionally offered by ABS include: 

• High, stable income—ABS subsectors such as residential and commercial mortgages, securitized pools of corporate loans, and bank regulatory capital transactions may offer predictable contracted cash flows (steady income streams) in a way that corresponds to an investor’s chosen risk profile. 
• Loss protection—Typically, the underlying assets of ABS are collateralized with a moderate loan-to-value ratio, providing a buffer against potential losses. Investors can choose from different tranches that align with their risk tolerance, ensuring that those willing to take on more credit risk can potentially earn higher returns.
• Relative value opportunities—In our view, ABS currently offers attractive relative value when compared with corporate credit, which has the equivalent credit rating, primarily to compensate investors for the complex nature of its structure.
• Short duration—The majority of ABS are floating-rate securities, which can help to mitigate interest rate risk. 
• Customization and diversification opportunities—Investors are able to access assets across different geographies, sectors, and parts of the capital structure and tailor their exposure according to their income needs and their risk appetite. 

Current opportunities in ABS

At present, we see compelling opportunities for investors across ABS subsectors. By focusing on credit quality, we believe investors can find ABS assets that can:

• Help protect against potentially deteriorating macroeconomic and borrowing conditions 
• Offer potentially high stable income that can help buffer portfolios against volatility 
• Have lower beta to broader market metrics and sectors that exhibit lower market correlation 

It’s worth noting that this asset class—and its various subsectors—requires detailed bottom-up credit analysis and sophisticated analytics capabilities to identify opportunities and actively manage their risks.

1 Bank regulatory capital relief

Regulatory capital relief is a risk-sharing strategy that’s taken shape as a direct result of increased capital requirements for large banks following the 2007/2008 global financial crisis (GFC). In our view, it’s an exciting, growing asset class that has the potential to provide attractive and stable income from primarily investment-grade corporate loan risk.

The introduction of stringent bank regulations following the GFC requires banks to increase their capital buffers. To improve their capital positions (free up capital), banks are able to share the credit risk of core high-quality loans through a securitization process and pay coupons to investors in return for sharing their risk burden. Through this arrangement, the issuing banks remain invested as they keep the most senior loan tranches with assets remaining on balance sheets. This is key because it means that the banks’ interests are aligned with investors. In these structures, banks include their highest-quality loans to pursue capital relief, which in turn enables them to issue more regulatory capital relief transactions.

European banks have been quick to take up the issuance of capital relief instruments relative to their international peers, but we’re now seeing a growing number of issuances in North America and Asia. The sector is expected to continue to grow and develop as capital requirements for large banks increase. The sector is enjoying annual growth of 20% to 25%, and issuance is currently ~US$22 billion per year.¹

Regulatory capital relief trades are at the intersection of ABS private credit and bank lending, two seemingly competitive forces brought together by the regulators. We believe regulatory capital relief offers a number of potential benefits for investors, striking a good balance between high income, high credit quality, and stable return potential.

2 Global CLOs

In our view, collateralized loan obligations (CLOs) offer the potential to generate strong risk-adjusted returns with robust credit protection, even in a scenario where sharp increases in corporate default rates could be likely. The floating-rate nature of CLOs enables investors to benefit from higher short-term rates and helps avoid significant rate duration in a portfolio.

Once again, an active approach is needed here because credit spreads typically move in line with the corporate cycle. Having the flexibility to rotate up and down the capital structure―in other words, moving between senior loan tranches, which have historically exhibited lower risks and are paid out first, and junior tranches, which offer higher premiums but also higher risk―and between geographies means investors may benefit from an evolving opportunity set.  

We believe that CLO tranches offer attractive relative value when compared with other corporate credit sectors while benefiting from structural credit protection against an increase in defaults. The sector has experienced muted default rates through multiple periods of stress, with only 0.33% cumulative defaults globally between 1996 and 2022 (across 22,210 Standard & Poor’s-rated CLO tranches).²

3 U.S. residential mortgage-backed securities

The U.S. Congress created two government-sponsored entities (GSEs), Federal National Mortgage Association (widely known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), to buy mortgages from lenders (e.g., banks and credit unions). This process enables lenders to originate more loans, allowing more individuals to buy homes. Meanwhile, a portion of the mortgages that were purchased by the GSEs are repackaged (or securitized) as credit risk transfer (CRT) securities and sold to investors as a way for the two GSEs to transfer some of the risks held by the government to CRT buyers.

In our view, this ∼$50 billion market,³ backed by several trillion dollars of mortgage balances, is an efficient way to gain exposure to standardized U.S. mortgage credit across a range of risk and return expectations. The value of U.S. residential housing stock has risen to around US$48 trillion while the quantity of mortgage debt in the United States sits at around US$13 trillion,⁴ only US$3 trillion higher than in 2007 even though the value of the housing stock has more than doubled over that time.⁵

The loan-to-value ratios of collateral backing these deals can range from as low as 30%, going up to 80% on new deals,⁶ offering investors a variety of risk exposures. We believe rising housing demand driven by the millennials—the largest generation in the country—will continue to provide support for home prices and, by extension, encourage strong credit performance. Like CLOs, the CRT sector offers investors the opportunity to express a core credit view through their portfolio allocation while tailoring it to the market’s perception of risk, thereby creating the potential opportunity to generate solid returns.

4 U.S. commercial real estate 

The commercial real estate (CRE) debt markets in the United States have produced attractive total return opportunities on both the long and short sides in recent years due to significant changes in the fundamentals of the underlying assets. The rise of online shopping and COVID shutdowns (which hurt mall revenues), work-from-home initiatives (which affected demand for offices), and a higher interest rate environment (which dented capitalization rates—a widely used measure of potential return on an investment property—and valuations) have created significant distress and uncertainty in the CRE and commercial mortgage-backed securities (CMBS) markets. Currently, we see attractive opportunities in seasoned, de-levered CMBS bonds (i.e., debt with lower levels of leverage and, therefore, associated risks) that were issued between 2010 and 2014; specifically, the senior tranches. In these instances, investment managers who have access to a team of ABS market specialists may be better positioned to tap into these opportunities. They can use their expertise and apply high-stress scenarios to the small number of remaining loans to assess if there's a possibility for a cushion on the return of principal while benefiting from the bond’s price sensitivity to changes in yield as a result of an earlier market adjustment.

Navigating associated risks

Investing in ABS involves various risks, many of which fixed-income investors will already be familiar with. These include credit default risk, liquidity risk, and mark-to-market volatility risk. Given the relative complexity of the asset class, we think it’s essential for investors to access ABS through a specialized investment manager. In our view, the breadth and depth of knowledge of the market, as well as actual experience, is critical here.

Here’s a quick checklist of factors that investors should consider when assessing ABS. In our view, an ABS manager should:

• Have the ability to conduct deep due diligence on the risks associated with investing in ABS markets
• Understand the nuances of the different subsectors of the ABS market
• Know what to look for when evaluating the credit risks of underlying assets in pools of collateral
• Possess the skills to assess prepayment risk
• Have a deep understanding of security’s structure and the relevant risk/return profiles of tranches in a specific capital structure

An established ABS manager should also be able to navigate market volatility and dislocations and assess the impact of regulatory changes and macroeconomic factors, helping to steer investors toward their goals.

An attractive segment of the credit market

We believe the ABS market offers the potential for high, stable income and capital protection to generate attractive, risk-adjusted returns. This is especially relevant in uncertain and volatile markets, such as the one in which we find ourselves. Introducing ABS to an investor’s portfolio may help provide returns and stability. In addition, ABS can also potentially help to mitigate downside risks, dampen volatility, and lower a portfolio’s correlation to the general market. Given the breadth, depth, and geographical reach of the ABS market, we believe it’s possible for investors to make attractive risk-adjusted returns from the asset class across market cycles.

1 Structured Credit Investor (SCI) database. 2 Standard & Poor's, September 30, 2024. 3 Bank of America Merrill Lynch, November 30, 2024. 4 Standard & Poor's, September 30, 2024. 5 “Default, Transition, and Recovery: 2022 Annual Global Leveraged Loan CLO Default and Rating Transition Study,” S&P Global, May 26, 2023. 6 Manulife | CQS analysis, as of December 31, 2024.