A byproduct of the low interest rate environment for fixed income investors is the need to “reach” for yield. This takes many forms, but ultimately investors must balance the need to continue purchasing assets (in traditionally unfavorable conditions) while adding yield to their portfolio. A common solution to this dilemma is to add riskier assets, which can help satisfy either side of the previously mentioned balancing act. Given this reality, subprime auto ABS are one corner of the market where managers may look to invest. However, these instruments are not without concern and have often drawn comparisons to subprime MBS. To investigate the recent negative sentiment, let’s review the asset class’ background, unique characteristics, and recent performance.
Auto ABS are car loans packaged together to form a collateral pool; this collateral pays interest (and eventually the principal of the loan) which is passed to investors depending on their claim to the cash flows. The loans that compose these collateral pools are bundled together based on the credit profiles of the individuals borrowing money. Subprime ABS issue cash flows ultimately depend on those with relatively poor credit profiles making their payments.
The story is similar to pre-crisis subprime MBS (though on a much smaller scale). Today's economy is, by many measures, as healthy as ever and relatively risky assets are structured in ways that offer varying levels of risk, reward, and protection. Unlike subprime MBS, however, subprime auto ABS survived the crisis and issuance is at all-time highs. The subprime auto loan business is a perfect fit for a low interest rate environment. Those making the loans can borrow for very little while marking up rates significantly because the other side of the contract has a low FICO score and minimal options for financing.
One of the key factors to look at when evaluating subprime auto ABS is tranche seniority. The same prime or subprime collateral pool will produce the cash flows for various tranches but each tranche will feature a different priority of payout. Overcollateralization and excess spread are common characteristics monitored by investors to determine their protection in the event that the underlying loans do not perform. Overcollateralization ensures that the underlying collateral exceeds the par value of the ABS issued, while excess spread refers to a surplus of cash flows coming off the collateral pool relative to those owed to ABS investors and fees. In either case, positive values indicate that there is a cushion in the event of defaults.
While all-time issuance highs may typically indicate optimism, there are several areas of concern. Certain underwriting practices in the auto loan industry have raised alarms, which is important to consider because this can create a disconnect between a borrower’s credit profile on paper compared to reality. In the past several years, there have been reports of dishonest income verification, an increase in the volume of borrowers rolling negative equity from an old loan to a new loan, and deteriorating FICO score profiles on the underlying loans. As seen with the mortgage crisis, if underwriting practices suffer in order to meet volume demands, investors will suffer the consequences. These reports are mainly citing auto-finance companies, but other issuers like car companies, banks, and credit unions have raised eyebrows as well.
On a more macro level, after almost a decade of historically low interest rates and positive returns, an economic downturn seems overdue. Incomes are rising, but so is consumer debt. Additionally, balance sheets are unwinding, the yield curve is flattening, and index levels are soaring. While these may have no direct impact on auto loan performance, it is not a stretch to imagine negative peripheral consequences on subprime borrowers in a less favorable economic environment.
To help quantify how the underlying collateral and ABS are performing, we built a portfolio of approximately 1,500 auto ABS tranches included in major indices over the last three years. Admittedly, index constituents are tilted towards higher quality, so the opposite end of the spectrum is likely underrepresented. This universe of securities is a combination of prime and subprime collateral as well as captive and non-captive issues. We segmented by captive (Honda, Ford, Toyota, etc.) and non-captive (auto-finance companies, banks, credit unions, etc.) issuers to highlight those viewed as most troublesome, namely auto-finance companies.
Reported delinquencies and constant default rates (CDR) tell the same story. Both metrics are relatively stable over time in all subcategories except for the subprime non-captive issues. Not only are both 30+ day delinquencies and one-month CDR significantly higher than their peers, they are trending upwards over time. The same relationship holds when you expand to longer periods of delinquency or observed CDR period, although the absolute levels drop.
Note that all aggregate statistics are weighted by the par value outstanding as of that period.
With prices hovering close to par, coupon is the main driver of return. The seniority decision mentioned earlier involves many factors, but put most simply is a risk/reward tradeoff easily observed through the inverse relationship between coupon and seniority. Consider the fixed rate deal examples below. The Credit Acceptance Loan Trust (subprime collateral) and Hyundai Auto Receivables Trust (prime collateral) were both issued in 2016. As expected, investors willing to accept more risk (through less credit-worthy collateral or subordinated claims to cash flows) are generally compensated with higher returns.
Conclusion
Understandably, investors are attracted to the idea of picking up the return that comes with a sacrifice in quality. Those invested in the space have and may continue to earn excess returns relative to other credit and securitized alternatives since aggregate spreads are at historical lows virtually across the board. Even in a worst-case scenario, subprime ABS do not pose the same systemic risk seen with subprime MBS a decade ago. However, underwriting trends and general credit well-being should be considered carefully to determine appropriate areas to take on more risk.