asset backed securitiesBoth individual and institutional investors are scrambling to find higher yielding financial products to meet future liabilities. Many have turned to equity products such as real estate investment trusts (REITs) and master limited partnerships (MLPs) to fill this need. But these are very volatile sectors, especially the energy-dependent MLP sector. (Many MLP owners are now turning to inverse oil etf to hedge a sector that has already been decimated). Other investors are turning to a small subsector of the fixed income space for above average yields. Enter the $1.2 trillion asset backed securities, or ABS market.

What are Asset Backed Securities?

Asset backed securities are fixed income structured products that are backed by financial assets, often scheduled loan repayments payments. They are purchased by yield-hungry institutional investors because many ABS offer a yield premium of around 200 basis points above comparable corporate bonds.1

There are several different types of asset backed securities. They include predominantly auto loans, student loans and credit card receivables but also more esoteric instruments including annuity payments and billboard leases. Here is a more comprehensive list of asset backed securities.

  • Auto Loans
  • Credit Card Receivables
  • Student Loans
  • Structured Settlements
  • Aircraft Leases
  • Franchise Royalties
  • Collateralized Loan Obligations (CLOs)
  • Timeshare Fees
  • Accounts Receivable Factoring

How Asset Backed Securities are Created

The process begins with an originator (typically some type of specialty finance company) making loans. Once the originating company has significant exposure, it sells the loans (transferring the risk) to what’s called a special purpose vehicle or SPV. The SPV, in turn, sells the newly created financial security to investors, hungry for whatever benefit the product provides. In the case of ABS, investors enjoy increased yield, shorter durations and [alleged] lower risk from the diversification the bundling creates.

A worrying sign is the seemingly insatiable appetite for these products from investors. As long as the demand for the ABS exist, the underlying loans will continue to be made, with decreasing credit quality. Why? Because the loan originators frankly don’t care what happens to the loans once they sell them off to a SPV. The risk has been transferred to them and soon to the investors themselves, tucked away in nameless, faceless pension fund or insurance company investment portfolio (both of which have benefit obligations to match).

The big three ABS, student loans, auto loans and credit cards have each topped $1 trillion in size, each fueled by securitization. Some worry these are clear signs of a bond bubble.

For student loans, there is what’s referred to as extension risk, or the delayed repayment of student loans. Of course, the trend towards student loan forgiveness is another risk. Delinquencies are also increasing at an alarming pace.2 Deflation forces are weighing heavily on the extinguishing of this type of debt and it’s even made its way into political rhetoric. This is an eerily similar flashback to the mortgage market of a decade ago.

The Danger of Asset Backed Securities

A problem with asset backed securities is that they are purchased under the guise of being low risk. In reality, these structured products are anything but. While the premise of diversification would lead buyers to think that buying a basket of higher risk securities actually lowers risk, when crises hit, this benefit goes out the proverbial window. For example, we saw what happened to these securities during the Financial Crisis as AAA-rated mortgage backed securities began plummeting like junk bonds.

In fact, speaking about the auto loan bubble, the U.S. Comptroller of Currency, Thomas Curry, warned last October that “What is happening in this space today reminds me of what happened with mortgage backed securities in the run up to the crisis”.3 Nearly a quarter of all loans are subprime and many auto loans are now seven years in length, (leading to more palatable monthly payments).4

Another risk is the limited amount of proprietary research done on the ABS market. The majority of analysts that do deep-dives into the space are buy-side analysts from hedge funds or private equity firms. Of course, with limited price transparency comes enormous opportunity for astute analysts. Many know the story of Michael Burry’s Scion Capital which made around $750 million for investors betting against mortgage backed securities (MBS are technically not asset backed securities but are similar in construct). Since it was impossible to actually short sell individual bonds, Burry purchased credit default swaps on the riskiest tranches MBS. An opportunity may exist for institutional investors to similarly pursue insurance if they are heavily exposed to some of the riskier sectors of ABS such as auto loans, almost a quarter of which is subprime.

Hedge Exposure to Asset Backed Securities

So now that we know what asset backed securities are and the danger they pose, what is the best way to hedge an investment portfolio from them? Unless you are an accredited investor you won’t own ABS directly, but you will still have plenty of exposure to them. Financial institutions, pension funds and life insurance companies are some of the largest owners of these structured products.

Further, some of these insurance companies are on the list of systemically important financial institutions, meaning they could be forced to maintain minimum tier one capital ratios. As such, they will or, at the very least, be hard-pressed to maintain an aggressive dividend policy. This is especially true for financials as much of the dividends being paid out by S&P 500 companies is coming from corporate debt issuance, which will be watched closely by regulators. Further, there’s no telling what rising interest rates will do to these products.

Reducing exposure to any financial stocks or ETFs such as XLF would be a way to indirectly reduce ABS exposure. ABS are also held inside many retail bond funds so take a closer look at your funds to see if you have outsized exposure or consider an inverse bond etf. Other options exist including  financial inverse ETFs such as SEF or even FAZ for more aggressive traders. Many 401k and ESOP plans have high percentages of company stock in the plans. The Prudential and Wells Fargo 401k are examples of over-concentrated plans.