Canceled Student Loans May Be Boon for Bonds

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The U.S. student loan forgiveness that progressives in Congress are calling for may not be a bad thing for investors in bonds backed by that debt, because owners of those securities are getting paid high enough yields to compensate for any early principal payments that may result.

The securities backed by loans originated under a now-defunct program called the Federal Family Education Loan Program, or FFELP, will likely sport higher returns than other floating-rate debt even if loan forgiveness leads to a spike in dreaded prepayments. The sector would become awash with liquidity as the federally-guaranteed loans are paid and the most distressed borrowers avoid default, market participants said.

“If the Biden administration implements some level of debt forgiveness -- $10,000 or $50,000 -- that may lead to prepayment risk, shortening the bonds,” Darrell Wheeler, head of securitized strategy at Cantor Fitzgerald LP, said in an interview. “But even in our shortest prepayment scenario, the bonds still offer an attractive spread pickup,” according to a recent analysis by the bank.

Canceled Student Loans May Be Boon for Bonds

Similar to mortgages in mortgage-backed securities, investors typically dislike when students prepay their loans early because it shortens the bond’s life and prevents them from collecting interest payments for an extended period of time. If the government pays off the student loans, it would essentially act as one big prepayment.

The impact of any forgiveness generally varies and depends somewhat on the price paid for the bond. While the loan forgiveness would prepay bonds and shorten the average life, it’s expected to be only a minor impact on the expected spreads, depending upon the price paid for the bond, according to Cantor’s analysis.

The government guarantee on FFELP student-loan bonds makes these instruments a compelling product to consider as rates rise, especially during an uncertain macro-economic future, Cantor says. Other floating-rate fixed-income products such as collateralized loan obligations, for example, have no such guarantee.

“Loan forgiveness could be a boon to student loan ABS by providing prepayments and liquidity immediately upon forgiveness,” Joseph Cioffi, a partner at Davis & Gilbert LLP, wrote in a Thursday blog post. “Whether the loans are federal or private, the lender would be paid and prepayment rates will go up but at least distressed borrowers will be less likely to default.”

Until July 2010, the FFELP program financed the majority of post-secondary education costs. Private institutions would arrange the loans with non-profit or state entities acting as guarantor, and the Education Department would essentially backstop or re-insure the guarantor. Significant loans were originated before the program ended and more than $250 billion of them remain outstanding today, according to Cantor, and they are still being packaged into new asset-backed securities.

The new stimulus package leaves the door open for potential student-debt forgiveness. Members of Congress would like President Biden to enact some level of forgiveness by executive order, but he has conveyed that he’d rather do it through congressional legislation.

Timing Problem

While there’s very little credit risk in FFELP ABS, there’s tremendous uncertainty over the timing of repayments, which can be problematic.

Loan forgiveness would shorten potential bond life, while Covid-driven deferrals, forbearance, and so-called income-based repayment programs delay repayment, leading to extension risk that may delay bond repayments beyond their final maturity. That could mean that senior tranches don’t get paid on time, or at all. This aspect drove many rating-company student loan ABS downgrades last year.

Like other asset-backed sectors, spreads on FFELP student loan bonds gapped out at the beginning of the pandemic but recovered over the summer and have since compressed at a steady pace, particularly when investors realized it was a maturity risk issue, not a credit-risk one, Wheeler said.

He believes that FFELP student loan ABS have recession-resistant value. Investors can get a floating-rate spread guaranteed by the Education Department during a period where rates may be rising, he said. On the other hand, if we get through the Covid stimulus spending and there’s a recession, these bonds still have the government guarantee.

“If I wanted to find a product that has a government guarantee, is floating-rate, and has a spread of 50 basis points to 70 basis points, FFELP student loan ABS would be it,” Wheeler said.

Relative Value: CMBS

  • Deutsche Bank AG analysts like junior AAAs and AAs at current spread levels in conduit CMBS deals, according to a Thursday research note
  • Single-A CMBS tranches appear fully valued, while BBB- bonds look rich given Covid loss uncertainty, the analysts said

Quotable

“Modest economic growth and an inflationary environment should support outperformance in the hotel segment, while retail property returns will likely lag,” said Harris Trifon, a portfolio manager and managing director at Lord Abbett. “Owners of hotels typically can reset the pricing of their leases (e.g., room rates) on a daily basis, exhibiting a high correlation coefficient with inflation. Additionally, travel demand has slumped well below what we would expect to see in a normal recession due to Covid-related travel restrictions and lockdowns. We see the potential for a surge in demand as early as the second quarter of next year, helping to drive upward pressure on room rates.”

What’s Next

ABS deals in the queue for next week include Pretium Partners (single-family rental), and Foundation Finance (home improvement loans).

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