The U.S. has taken several steps to relieve borrowers of their federally-held student-loan payments. Now, those measures may have a ripple effect on the bonds that bundle other kind of student debt.
Earlier this month, the government extended the pause on the payments and accrual of interest on student loans held by the federal government for the sixth time, providing some relief to the 43 million Americans who struggle with the outstanding debt. But the allure of the moratorium and other Covid-related relief programs for borrowers who don’t have federally-held loans could lead some to switch their older debt for new loans that do qualify for the benefits, said Theresa O’Neill, strategist at BofA Securities, in a phone interview.
“There’s a borrower who wants to take advantage of the payment options available in federally-held loans instead of older bank-held debt,” she said.
Although most student debt is backed by the Department of Education, there are some loans that predate 2010, which are held by private companies. Those older bank-owned loans, which are part of the Federal Family Education Loan Program, are repackaged into bonds that trade in the asset-backed securities market. But the FFELP market has been slowly shrinking, as no new loans have been originated in over a decade and borrowers are repaying their debt, taking the few loans that exist out of the market.
Now, the appeal of student loan payment relief programs might slash the market -- which stands at around $118 billion according to BofA, citing Department of Education figures -- even further. In comparison, the direct loan program, which qualifies for the moratorium and has the Department of Education as the lender, accounts for almost $1.4 trillion.
Unlike most borrowers, those with FFELP loans haven’t received any relief during the pandemic, having to continue making their payments throughout these past two years. But seeing their counterparts pause their payments might lead some to switch up their debt, especially if they expect the moratorium to be further extended. Some Senate Democrats have already urged President Biden to extend the relief through 2023.
“If I am a FFELP borrower and I want to take advantage of the payment pause, I need to move my FFELP loan into the direct loan program,” said O’Neill.
Read more: BofA Sees Relative Value Trades in ABS Amid Spread Widening
These borrowers are likely to get direct loans and use the proceeds to pay off their FFELP debt, which is held in the ABS market, she said. As repayments trickle in, bondholders may get their cash back earlier than anticipated. Some will lose money -- if they first bought the security at a premium -- while others will make good returns -- if they purchased it at a discount.
But as a result, the FFELP ABS market will shrink. “There’s consolidation going on in the FFELP ABS market since the pause has been in place,” said O’Neill.
Loan forgiveness?
A second type of borrower might cause further pain to the FFELP ABS market: public workers.
In October of last year, the government added a new Covid-related policy for FFELP borrowers who hold roles such as teachers, firefighters or nurses. Under the measure, these borrowers can access the Public Service Loan Forgiveness program, which is meant to forgive student debt of public servants after 10 years of on-time payments, for a limited amount of time, ending in October.
If they consolidate their FFELP debt --which originally doesn’t qualify for forgiveness -- into direct loans, they can count their past years of repayment towards the forgiveness.
To be sure, not all market participants believe borrowers might switch one loan for the other, saying that the extension on its own is not a strong enough incentive for debt consolidation. “The extension of the moratorium alone is not going to affect prepayment in FFELP ABS,” said Jinwen Chen, credit analyst at Moody’s Investors Service, in an interview. “The PSLF waiver could have more of an impact on prepayment, however.”
Once repayments start by the end of the summer, borrowers are likely to struggle. More than half of borrowers said in a survey this month that they wouldn’t be able to make a single monthly payment now if they had to. But the dire situation of the consumer might not have an impact on the ABS market, said analysts.
“FFELP borrowers have not benefited from the moratorium and they are fairly seasoned, so we won’t see much change in their behavior as a result of the moratorium extension,” said Nicky Dang, a structured finance analyst at Moody’s.
Relative value: ABS
- BofA strategists prefer subprime auto loan ABS over prime auto loan ABS for the incremental spread, according to a weekly securitizaton report. The analysts also believe there is enough structural protection to offset weaker credit performance in the subprime sector
- BofA also prefers prime auto ABS platforms that offer incremental spread
- However, the analysts prefer retail lease auto ABS over prime auto, and like subprime deals more than consumer loan ABS, they said
Quotable
“If you’re fearing rising rates, and looking to shorten duration, agency MBS is one way that you can and also not give up any spread,” Morgan Stanley Investment Management portfolio manager Andrew Szczurowski said in an interview. “Moreover, MBS is a AAA government-agency asset. Only a sliver of investment-grade corporate bonds are AAA, and only a small fraction is AA.”
What’s Next
ABS deals in the queue include Automotive Credit Corporation (subprime auto), Capital One (prime auto), DLL (small ticket equipment), and Octane Lending (power sports equipment)
