(Bloomberg) -- President Joe Biden's student loan forgiveness program could upend a more than $100 billion market for bonds which repackage older student debt, rerouting funds to a small suite of other floating-rate structured products instead.
The administration revealed a raft of student-loan relief measures last week, which will forgive as much as $20,000 in federal debt held by some 43 million Americans. But the plan is also likely to incentivize borrowers to swap older, bank-owned loans that don't qualify for the benefits for new loans that do qualify under the Direct Loan program. This would slash in half the existing Federal Family Education Loan Program (FFELP) asset-backed securities market financed by those older loans predating 2010, according to BofA Securities.
As a result, money managers holding FFELP ABS could get their money back earlier than expected. Around 50-60% of the $100 billion market is expected to be paid down within the next six to nine months, BofA predicts. Moreover, much of that roughly $50-60 billion may be funneled into a handful of other floating-rate asset-backeds, such as collateralized loan obligations (CLOs) -- bonds backed by leveraged loans -- or single-asset, single-borrower commercial mortgage-backed securities (SASB CMBS), according to the bank.
"Most of those FFELP ABS investors had floating-rate bonds, so you'd assume they would want to go back to the floating-rate universe once they get the money back," explained Pratik Gupta, BofA's head of CLO and RMBS research, in an interview. "And CLOs are one of the few asset classes that provide a scalable investment opportunity in floating-rate investment-grade bonds."
No new FFELP loans have been originated since the namesake program came to a halt over a decade ago, which means that as borrowers repay their debt and wipe out existing loans, the FFELP ABS market has steadily shrunk in size too. On average, about $6 billion of new FFELP ABS deals came to market every year between 2018 and 2021, but that supply has since dried up, with zero deals issued in 2022, according to a Deutsche Bank report.
Alternative Floaters
The floating-rate ABS market has been dwindling for at least a decade, with total issuance falling to a meager 4% in 2021, from 37% in 2012, due to a lack of new FFELP loans and a pullback in credit card-backed deals, Deutsche ABS strategists Kayvan Darouian and Andrea Andric wrote in their Aug. 29 note. The decline in FFELP ABS deals is likely to aggravate this downtrend further.
"With much of the outstanding FFELP SLABS universe potentially paying down, the ABS market would have fewer alternatives for investors looking to source floating rate paper," add the analysts.
Money managers may seek solace in the $1 trillion floating-rate CLO market, which repackages leveraged loans according to varying levels of risk and return before selling them to investors. Spreads on the securities are also somewhat wider compared to FFELP ABS -- AAA CLOs were seen trading at 165 basis points last week, compared to 105 basis points on the equivalently-rated tranche in student debt-backed securities, according to BofA.
Another floating-rate asset class that stands to subsequently benefit from more funding is SASB CMBS. The bonds are backed by mortgages tied to a single property or cluster of properties, all from the same borrower, which are securitized and sold. The safest tranche of a deal in mid-August priced at 340 basis points over the benchmark rate.
It should be noted that the SASB sector is considerably smaller than its CLO counterpart, with year-to-date issuance coming in at just under $40 billion, while the latter has already raised nearly $92 billion, according to data compiled by Bloomberg.
To be sure, not all the cash from the FFELP ABS paydowns is expected to be invested in floating-rate assets, and even if it is, the reallocation probably wouldn't dislocate the market for floaters by too much, at least in the near-term. It "may not be enough to move CLO spreads, but it will help at the margins to the extent this capital is deployed all at the same time," said Gupta.
Other floaters in the structured market include credit risk transfer bonds, i.e. bets on homeowners repaying their loans, and commercial real estate-backed bonds that bundle construction loans and other types of real estate debt. So far this year, CRE CLO issuance stands at a little under $26 billion -- somewhat higher than the $24.8 billion at this time last year -- while Freddie Mac and Fannie Mae CRT sales total $18.1 billion, compared to $6.9 billion at this point in 2021, according to Bloomberg data.
Relative Value:
- Investors' sentiment was dampened by the Federal Reserve's resolute stance in fighting inflation by raising and keeping rates higher for longer, meaning risk assets will suffer in the short-term but could do well long-term, according to Tracy Chen, head of structured credit at Brandywine Global Investment Management
- Although some higher beta sectors have seen spreads widening this week, such as CLOs, CRTs and CMBS, "spreads should go wider until the Treasury market stabilizes," said Chen. "There's nowhere to hide when real yields rear its head"
- However, Chen is constructive on subprime auto and consumer loan deals of top-tier issuers, as student loan forgiveness should be a positive to some kinds of consumer debt
Quotable
"If growth starts to falter and we start heading into a recession and we see the Fed not responding because they're still worried about inflation, I think that's when default risk starts to reprice," Priya Misra, global head of rates strategy at TD Securities, said on Bloomberg Television last Friday. "It's hard for me to be very positive on credit here."
What's Next
ABS deals in the queue include an additional $250 million in issuance to last June's AFFRM 2022-A point-of-sale trade from Affirm.
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