Asset-backed securities are often a misunderstood asset class, despite having many compelling characteristics including a potential return premium and a defensive capital structure. These, in our view, make them well-suited as a tool for inclusion in defined contribution (DC) default strategies.
Asset-backed securities (ABS) are credit instruments – i.e. bonds – secured against a collective pool of underlying assets. Investors who are unfamiliar with ABS often have pre-conceptions about the asset class and approach with caution. Many will still have vivid memories of the Global Financial Crisis (GFC), during which US sub-prime assets were at the centre of the turmoil. However, there are key structural differences between US and European ABS, which have led to a markedly different experience for investors in those markets.
Despite the UK's defined benefit pension schemes taking advantage of the opportunity in European ABS over the last decade, the asset class is underrepresented in DC pension portfolios today. ABS strategies vary widely and cater to different preferences and risk appetites, however we believe several core characteristics can make the asset class attractive for inclusion as part of a diversified fixed income allocation.
Key reasons for DC schemes to consider ABS:
- ABS generally offer a return premium over equivalent rated corporate bonds, supporting the growth of savings over time.
- Their floating rate structure can help protect savings in inflationary environments.
- DC schemes could create more resilient default fund structures by diversifying fixed income risk with ABS.
- It is typically a defensive asset class that can protect members' savings during volatile periods in markets.
How ABS could help grow DC savings
European ABS offer a pickup in yield versus equivalently rated corporate bonds across rating bands, meaning there is potential for investors in the asset class to earn a return premium and help grow DC savings. The higher returns potentially available in European ABS are due to structural factors and in our view, are not a reflection of higher credit risk.
ABS have usually delivered a persistent return premium over equivalently rated corporate bonds over time. The differential is primarily explained by:
- Complexity premium
ABS is a specialist asset class which requires extensive and detailed knowledge. Assets therefore trade with additional spread to account for this ‘complexity premium'.
- Behavioural biases and misconceptions
Investors' anchoring to negative experiences in the US sub-prime market has created a persistent valuation anomaly in European ABS markets, which have demonstrated high levels of structural resilience, large liquid trading volumes and a return premium over equivalently rated corporate risk.
- Harsh capital treatment for certain investor types
Capital charges to hold ABS for banks and insurance companies are far higher than for other corporate, covered or government bonds, which moderates demand for the asset class. Pension funds and other investor types operate under different regulatory frameworks, which do not impose the same stringent capital requirements for ABS holdings.
- Regulatory hurdles in ABS investment
ABS fund managers are required to fulfil extensive due diligence and stress testing requirements. These regulatory hurdles create barriers to entry, limiting the ability of new investors to penetrate the market.
The spectrum of ABS spans from AAA through to mezzanine and subordinate tranches, which can perform distinct roles in a default fund. We view senior asset-backed securities (AAA) as an accessible first step into ABS for those investors seeking a yield-enhancing alternative to long-term cash holdings (given the higher liquidity) in the latter stages of an accumulation phase journey (or through into retirement solutions). Alternatively, investment grade securities (AA/A) can complement existing holdings, by delivering a yield premium and improving diversification in a portfolio of fixed income assets.
