European asset-backed securities (ABS) ‘tick all the boxes’ for investors seeking assets with higher yields and lower interest rate sensitivity as market fears about central bank tapering continue to mount, according to Aegon Asset Management’s Egbert Bronsema.
Interest rates have been moving higher in recent weeks amid investor concerns that central banks will scale back monetary policies in response to strong economic growth and signs that inflation pressures may not be temporary.
“The market is getting increasingly worried about the US Fed’s tapering intentions despite Chair Jay Powell’s dovish comments at the Jackson Hole symposium,” says Bronsema, fixed income manager at Aegon AM. “Meanwhile the ECB will have difficulties in communicating its strategy to keep markets at bay as inflation pressures might not be temporary, while PEPP purchases will already be scaled down.”
“Against this backdrop, volatility on interest rates has increased again and demand for assets with lower interest rate sensitivity and higher yield (due to carry) is continuing. European ABS stands to benefit, as it ticks all these boxes.”
Bronsema says that while markets have priced in good news, any surprises in terms of macroeconomic data or a renewed COVID outbreak will result in volatility, especially for longer duration assets.
“The uncertainty around tapering and the path of rates increases the demand for short duration assets as performance will not depend on these moves,” Bronsema says.
“European ABS offers these distinct benefits, as it is one of the few liquid asset classes with floating rate coupons. Even though spreads are at or even tighter than pre-pandemic levels, European ABS valuations still look compelling across credit markets. Spreads are still lagging other markets and convergence should limit spread widening. We therefore favour European ABS bonds in an environment of real rate increases particularly coupled with its relatively high carry, which currently stands at approximately 75bps above investment grade credit.”
With the summer break over, Bronsema believes issuance levels should continue to increase – there have been 10 deals that have or are looking to price over the last two weeks – as lending volumes edge up due to the reopening of the European and UK economies.
“Notwithstanding the heavy issuance, demand is still outpacing supply,” says Bronsema. “With monetary support from the ECB still very accommodative, spreads in other fixed income markets are at historic lows and while economic activity is set to pick up, risk appetite and the search for yield continues. European ABS still has attractive carry, and we therefore expect the demand/supply technical to continue and issuance conditions to remain favourable.”
Finally, Bronsema believes that fundamentals remain supportive, even if there is a fine balance to be struck between the scale-down of policy support measures and economic growth, which will impact European ABS performance.
“Even with a pick-up in delinquencies, ABS structures can withstand substantial stress scenarios and payment disruptions through structural elements like (liquidity) reserve funds, excess spread, cashflow diversion triggers and subordination, which have almost all increased in newly issued ABS.
“As things stand currently, spreads across European ABS are still relatively attractive and there remains room for spread tightening due to the strong technicals, which eclipses any (short term) fundamental concerns of investors.”