Investors Are Doing a Deep Dive Into the Riskiest Subprime Debt

(Bloomberg) -- Investors hunting for better returns are doubling down on risk in far flung corners of the U.S. bond market.

Nowhere is this more striking than in the markets for asset-backed securities and collateralized loan obligations. Below-investment-grade ABS are on track this year to account for its biggest slice of the overall sector since before the financial crisis. At the same time, the riskiest CLO notes are now a larger percentage of the market than they’ve been in two years.

The growing appetite for the lowest-rated bonds in the ABS and CLOs markets highlight the rabid demand for higher-yielding securities and those with floating rates that offer protection from inflation and tighter monetary policy. But this also leaves these markets more exposed at a time when many analysts see an economic slowdown on the horizon.

“From a debtholder’s perspective, I am very wary of these types of lower-rated tranches, as they have been shown to have much more spread volatility and much more rating risk,” said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management, about the collateralized loan obligation and asset-backed securities markets.

Subprime ABS

The supply of below-investment-grade asset-backed securities in consumer categories has been rising for the last two years with the majority in personal loans, equipment and auto, according to Wells Fargo.

Subprime auto ABS is the largest category. Companies have sold more than $150 million of B rated bonds in the sector this year, compared with nothing last year and an annual average of about $20 million since the financial crisis, Barclays analyst Alin Florea wrote in a recent note. It’s still a small part of the overall market.

The popularity of subprime auto ABS -- especially the rise of B rated tranches -- is a concern because there are fewer protections baked into the structures of the deals than before the financial crisis, S&P Global Ratings analysts said in a note Monday.

Bonds rated BB typically were insured in the 1990s, featuring important triggers to protect investors. But insurance hasn’t been used as a form of credit enhancement in this market since 2008, so the latest batch of subprime deals -- many of which now go all the way down to B ratings -- doesn’t have the same safety net, according to S&P.

“Given the lack of triggers and the growing popularity of B rated classes in subprime auto loan ABS, the market is bearing similarities to the speculative corporate bond market where covenant-lite structures are abounding,” S&P analyst Amy Martin wrote. “The low-interest-rate environment and low default history has resulted in an increasingly borrower-friendly leveraged finance condition as investors seek higher yield.”

Bundled Loans

The share of deals issued with B rated tiers in the CLO market has increased to 30 percent of new issues compared with 17 percent last year and 3 percent in 2016, according to Nomura.

“When I consider the CLO downgrades that come across the wire, the vast majority of them are single-B to CCC downgrades,” said Merrill, whose firm has more than $24 billion of assets under management.

For example, Moody’s Investors Service downgraded the B2 rated tranche of a 2014 CLO managed by Invesco last week, while upgrading or affirming the ratings in the higher tiers.

The push into the lowest rungs comes amid record demand. New CLO deals may be on pace to reach an all-time high of $150 billion this year, according to Wells Fargo.

“In long periods of low volatility, investors can become accustomed to carry-like returns,” Merrill said. “However, this rule of thumb can break down when it comes to single-B issuance, which in my mind could be the first area of the capital stack to exhibit strong negative returns at the onset of the turning of the cycle.”

To contact the reporter on this story: Adam Tempkin in New York at atempkin2@bloomberg.net

To contact the editors responsible for this story: Christopher DeReza at cdereza1@bloomberg.net, Randall Jensen, Jeremy Herron

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