By Hamlin Lovell, NordicInvestor
With interest rates in the Eurozone, Denmark and Sweden having been negative for some years (and remaining very low in Norway) investors are considering a switch from fixed rate assets – which may suffer capital depreciation from rate rises – to floating rate assets, which should see their coupons increase when and if rates rise. Nordic Investor spoke to Balint Vagvolgyi, a senior portfolio manager at Aegon responsible for ABS, CLOs and macro positioning.
The ECB is unlikely to raise rates until inflation accelerates. Inflationary pressure is not yet evident in Europe, but Vagvolgyi observes that “a shift in wage bargaining power to employees may spill over into inflation”. Still, he views the Eurozone monetary policy cycle as being about two years behind that of the US, and does not expect ECB rate rises until the second half of 2019.
Balint Vagvolgyi, Senior Portfolio Manager ABS & CLO – Aegon Asset Management
Currently, most pools of ABS are indexed to LIBOR (for sterling debt) or EURIBOR (for euro debt), which is also the reference rate for swaps. Interest rate benchmarks are in a state of flux, and reforms to the LIBOR rate-setting mechanism lie ahead, but Vagvolgyi expects “small tweaks rather than major changes to the arbitrary rate-setting procedure”. He jests “the lawyers will be happy with the extra work created by the documentation, but we do not expect major changes”.
In a positive rate environment, increases in ECB policy rates should feed through to floating rate debt yields within three months, and sometimes faster than this. In 2018 or 2019, the first interest rate rises may not immediately percolate into all floating rate debt yields however, because some ABS paper has a reference rate, or an overall coupon, floored at zero, Vagvolgyi explains. Once ECB rates move into positive territory, then all further rate rises should lead to higher yields on floating rate debt for ABS. (For leveraged loans and corporate debt, the floors can be higher, so it may take greater rate rises before yields increase).
How much value remains in ABS and CLOs? Vagvolgyi argues that “Leveraged loans, paying approximately 350 basis points over LIBOR, are still attractive in a low default environment, but is priced for perfection given that historical default rates around 2.5%”.
Spreads on ABS have compressed to the point where investors seeking a high single digit yield from ABS, may need to consider more junior paper, including mezzanine and equity tranches. But there is a large group of “AAA” investors, including insurance companies, who are content with a yield of say 80 basis points over a EURIBOR benchmark floored at zero. The Aegon European ABS fund targets EURIBOR+140 basis points from investment grade ABS, including 75% senior and 25% junior paper. It invests in Euro and Sterling denominated ABS, which can sometimes include overseas issuers – such as Swedish mortgages – or US student loans, securitised into a Euro structure.
Leveraged loans, paying approximately 350 basis points over LIBOR, are still attractive in a low default environment, but is priced for perfection given that historical default rates around 2.5%.
Vagvolgyi finds that ABS yields still offer a good risk premium given default risks. The Aegon ABS strategy has had no defaults since inception in 2004. By way of comparison, the European floating rate ABS market has seen cumulative defaults of 2% between 2007 and 2017. (The US ABS market has seen cumulative defaults of 20% over the same period, of which 16-17% was sub-prime RMBS).
Absolute yields are clearly higher in the US, but so too are interest rates. Focusing on spreads over the risk-free rate, “on CLOs backed by bank loans, spreads are very comparable hedged back to Euros” he observes. But mortgages are somewhat more complicated. “The comparison is not straightforward as the market structure is different. Most US mortgage lending is done through agencies, such Freddie Mac and Fannie Mae. Being government-guaranteed, it offers a small illiquidity pickup over Treasuries. Non-agency US mortgages are mainly more esoteric and offer more risky collateral. In Europe, spreads on prime ABS are somewhere between US agency and non-agency spreads, but there is quite a wide range, with AAA paper going from 15 to 85 basis points” he adds.
Tapering and unwinding QE
ECB tapering and unwinding of QE is expected to gather pace, before any rate rises. Vagvolgyi anticipates that this may have a marked impact on corporate floaters and covered bonds, where the ECB buys a very significant portion of the new issue market. He expects ABS could prove more resilient, partly as the ECB only makes up around 5% of the outstanding market, and also because other groups such as money market funds and Banks’ treasury departments could take the place of the ECB.
A more nuanced question is to what extent eventual higher interest rates might reduce credit quality, by making debt servicing costs less affordable for consumers or companies. In general, he anticipates “the ECB will only raise rates if the economy is growing, so if wages and company profits are rising, borrowers will then be in a better position” However, the impact varies by asset classes and geographies. “In the UK and Spain, mortgage costs rise quite quickly after a rate rise as mortgages tend to have short fixed rate periods. In the Netherlands, mortgage rates can be fixed for up to thirty years so it takes more time before costs rise” he explains.
buy to let mortgages, which are almost entirely a UK phenomenon, could prove more vulnerable, if landlords are not be able to raise rents by enough to cover higher loan costs.
Overall, he does not expect that mortgage defaults would be as bad as those seen in the 2008 crisis, though some pockets of the market could be hurt. For instance, buy to let mortgages, which are almost entirely a UK phenomenon (with only one such pool securitised in the Netherlands) could prove more vulnerable, if landlords are not be able to raise rents by enough to cover higher loan costs.
House prices and unemployment
Collateral coverage on ABS is strong for several reasons. In most countries, it is not possible to borrow more than 70-90% of a house price value. And house price appreciation has reduced loan to value ratios, on seasoned pools. Structured ABS has further protections from first loss equity tranches that would take the first hit anyway. Moreover, structural changes in mortgage markets are reducing risk as interest-only mortgages are a diminishing proportion of the market. For instance, the Netherlands only offers tax deductibility for amortising, or repayment, mortgages, which means that loan to value ratios will fall over time- even without further house price rises.
even when property prices fell a lot in Europe, dragging borrowers down into a negative equity situation, they kept on paying mortgages. Unemployment may therefore be more important than property prices in Europe.
Property prices are more relevant in the non-recourse US mortgage market than in the European market, where, if proceeds from a property sale fall short of a loan value, lenders have full recourse to all assets and income of a borrower. History shows that even when property prices fell a lot in Europe, dragging borrowers down into a negative equity situation, they kept on paying mortgages. Unemployment may therefore be more important than property prices in Europe.
If the worst comes to the worst, and lenders have to foreclose, what are costs and recovery rates? “They are typically 5-10%, but are higher for smaller loans, and our stressed case assumes 15% costs and 90-95% recovery rates, also factoring in some property price declines. Currently, property is worth so much relative to loans that you might see 100% recovery rates” says Vagvlogyi. The servicer would typically handle foreclosures. In Europe, the mortgage lender is usually also the servicer, though sometimes special servicers may be used.