Are Subprime Auto ABS Still Worth the Risk?

When I last wrote about auto ABS, there were some concerns in the market and media on the levels of subprime auto loan issuance and the lending practices from banks, credit unions, and finance companies. As detailed previously, despite the increasing volume of underlying loans being made to borrowers with lower FICO scores, this is not necessarily a negative for auto ABS investors because securitization creates cushion in the event of defaults and allows investors to choose different levels of risk and return.

To provide a timely update, I will need to acknowledge the elephant in the room: financial markets have seen tremendous volatility and the economy is seeing (or on the verge of seeing) unprecedented levels of government stimulus due to the global pandemic. In some cases, lenders are relaxing contractual payment schedules on debt to provide relief to individuals during this trying period. It is impossible to say what the future holds, but this is a time filled with unknowns for many, including investors with assets dependent on the cash flows from consumer debt products with record-high unemployment and significant economic slowdown.

Macro Landscape, Loan Performance, and Origination

National debt levels are skyrocketing with the massive amount of economic stimulus coming from the government. However, before the pandemic took hold of financial markets and government policy, consumer debt continued to steadily increase over the last few years with auto loans as the consistent second-largest source of non-mortgage debt.

Serious auto loan delinquencies are low relative to other sources of non-mortgage debt but have shown a slight upward positive trend through the end of 2019.

And finally, absolute origination auto loan volume continues to trend upward. Subprime loan origination is largely in-line with recent levels from the last few years.

Index Analysis

After reviewing the “macro” landscape related to auto lending, I was curious to see auto ABS performance relative to other securitized assets and understand any fundamental changes over the last several years in auto ABS. To accomplish this, I focused on the auto ABS portion of the U.S. ABS and CMBS index. As a starting point, I wanted to understand if the aggregate characteristics materially changed. Largely, they remained consistent from the sample analytics I chose to review; however, there are some noticeable decreases in the weighted average coupon (WAC) of the collateral pool as well as significant increases in option adjusted spread (OAS).  

12/31/2018:

3/31/2020:

As expected, the higher quality auto ABS backed by prime collateral saw a softened spread increase relative to their subprime counterparts and even the aggregate ABS sleeve of the index. Note, fixed income investors are seeking opportunities where spreads are contracting because this will lead to price appreciation. The massive relative increase in spread is likely not speaking directly to the actual underlying loan performance backing these ABS, but instead an unavoidable side effect of market turmoil and uncertainty.

Auto ABS are short-duration assets, which means that relative to longer-dated bonds, they have less price sensitivity to changes to the yield curve. Another side effect of the pandemic is that already suppressed interest rates have been pushed lower across the whole curve, which from a bond-math perspective, is positive for fixed-income investors.

But rates and spreads moving against each other so drastically during this time period creates significant, but offsetting, swings in shift (duration) return and spread change return.   

The higher quality auto ABS backed by prime collateral are significantly outperforming their subprime peers and even the aggregate ABS sleeve of the index shows a sharp rebound from the peaks of volatility in mid to late March and less drawdown susceptibility.

What Comes Next

Certainly, the best outcome for all will be for life and business to get back to normal so that consumers can return to work, earn a paycheck, and pay their bills, but it is yet to be determined when that will happen. This has implications far beyond the microcosm of auto ABS investors and at this point, fiscal and monetary policies are clearly seeking to help a struggling consumer base and economy. While not totally immune to the recent volatility, securitized products should continue to be a relative haven compared to most other risk assets.